CHAPTER 2 1.

As a rule of thumb, real rates of interest are calculated by subtracting the inflation rate from the nominal rate. What is the error from using this rule of thumb for calculating real rates of return in the following cases? Nominal rate (%) Inflation rate (%) Solution:
Nominal rate(%)(NR) Inflation rate(%) ( IR) Real rate by the rule of thumb(%) Correct rate(%)=(1+NR)/(1+IR)-1 Error from using the rule of thumb(%) 7 4 3 2.88 0.12 12 6 6 5.66 0.34 18 8 10 9.26 0.74 22 10 12 10.91 1.09

7 4

12 6

18 8

22 10

2.

As a rule of thumb, real rates of interest are calculated by subtracting the inflation rate from the nominal rate. What is the error from using this rule of thumb for calculating real rates of return in the following cases? Nominal rate (%) Inflation rate (%) 4 1 8 3 11 2 19 4

Solution:
Nominal rate(%)(NR) Inflation rate(%) ( IR) Real rate by the rule of thumb(%) Correct rate(%)=(1+NR)/(1+IR)-1 Error from using the rule of thumb(%) 4 1 3 2.97 0.03 8 3 5 4.85 0.15 11 2 9 8.82 0.18 19 4 15 14.42 0.58

CHAPTER 3 1. At the end of March, 20X6 the balances in the various accounts of Dhoni & Company are as follows: Rs. in million Accounts Balance Equity capital Preference capital Fixed assets (net) Reserves and surplus Cash and bank Debentures (secured) Marketable securities Term loans (secured) Receivables Short-term bank borrowing (unsecured) Inventories Trade creditors Provisions Pre-paid expenses 120 30 217 200 35 100 18 90 200 70 210 60 20 10

Required: Prepare the balance sheet of Dhoni & Company as per the format specified by the Companies Act. Solution: Balance Sheet of Dhoni & Company As on March 31, 20 X 6 Liabilities Share capital Equity Preference Reserve & surplus Assets Fixed assets 120 Net fixed assets 30 200 Investments Marketable securities Current assets, loans & advances 100 90 Pre-paid expenses Inventories 70 Receivables Cash & Bank 60 20 690 217

18

Secured loans Debentures Term loans Unsecured loans Short term bank borrowing Current liabilities & provisions Trade creditors Provisions

10 210 200 35

690

2.

At the end of March, 20X7 the balances in the various accounts of Sania Limited are as follows: Rs. in million Accounts Balance Equity capital Preference capital Fixed assets (net) Reserves and surplus Cash and bank Debentures (secured) Marketable securities Term loans (secured) Receivables Short-term bank borrowing (unsecured) Inventories Trade creditors Provisions Pre-paid expenses 250 80 380 350 100 190 30 120 420 110 310 90 70 20

Required: Prepare the balance sheet of Sania Limited as per the format specified by the Companies Act. Solution: Balance Sheet of Sania Limited as on March 31, 20 X 7 Liabilities Share capital Equity Preference Reserve & surplus Fixed assets 250 Net fixed assets 80 350 Investments Marketable securities Current assets, loans & advances 190 120 Pre-paid expenses Inventories 110 Receivables Cash & Bank 90 70 1260 380 Assets

30

Secured loans Debentures Term loans Unsecured loans Short term bank borrowing Current liabilities & provisions Trade creditors Provisions

20 310 420 100

1260

3.

The comparative balance sheets of Evergreen Company are given below: Owners' Equity and Liabilities Share capital Reserves and surplus Long-term debt Short-term bank borrowings Trade creditors Provisions Total Assets Fixed assets (net) Inventories Debtors Cash Other assets Total As on 31.3.20X6 70 40 80 80 40 10 320 120 90 60 25 25 320 (Rs. in million) As on 31.3.20X7 70 80 90 85 70 20 415 210 95 65 30 15 415

The profit and loss account of Evergreen Company for the year ending 31st March 2007 is given below: (Rs. in million) Profit & Loss Account for the Period 1.4.20X6 to 31.3.20X7 Net sales Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Selling, administration and general Depreciation Operating profit Non-operating surplus or deficit EBIT Interest Profit before tax Tax Profit after tax Dividends Retained earnings 750 505 290 105 110 245 135 120 15 110 (20) 90 25 65 15 50 10 40

Required:

(a) Prepare the classified cash flow statement for the period 1.4.20X6 to 31.3.20X7 (b) Develop the cash flow identity for the period 1.4.20X6 to 31.3.20X7

Solution: A. Cash flow from operating activities - Net profit before tax and extraordinary items - Adjustments for Interest paid Depreciation - Operating profit before working capital changes - Adjustments for Inventories Debtors Trade creditors Provisions Increase in other assets - Cash generated from operations Income tax paid - Cash flow before extraordinary items Extraordinary item - Net cash flow from operating activities Cash flow from investing activities - Purchase of fixed assets - Net cash flow from investing activities Cash flow from financing activities - Increase in loans - Dividends paid - Interest paid Net cash flow from financing activities Net increase in cash and cash equivalents - Cash and cash equivalents as on 31.03.20X6 - Cash and cash equivalents as on 31.03.20x7 It has been assumed that “other assets” represent “other current assets”.

85 25 15 125 (5) (5) 30 10 10 165 (15) 150 (20) 130 (105) (105)

B.

C.

15 (10) (25) (20) 5 25 30

D.

Note

(b) A.

Cash flow from assets - Operating cash flow - Net capital spending - Decrease in net working capital - Cash flow from assets Cash flow to creditors - Interest paid - Repayment of long term debt - Cash flow to creditors Cash flow to shareholders - Dividends paid - Net new equity raised - Cash flow to shareholders

90 (105) 35 20

B.

25 (15) 10

C.

10 0 10

We find that (A) i.e., Cash flow from assets = = (B) + ( C) Cash flow to creditors + Cash flow to shareholders

4.

The comparative balance sheets of Xavier Limited are given below: Owners' Equity and Liabilities Share capital Reserves and surplus Long-term debt Short-term bank borrowings Trade creditors Provisions Total Assets Fixed assets (net) Inventories Debtors Cash Other assets Total As on 31.3.20X6 20 10 30 15 10 5 90 16 44 20 5 5 90 (Rs. in million) As on 31.3.20X7 30 18 25 15 15 8 111 20 55 21 8 7 111

administration and general Depreciation Operating profit Non-operating surplus or deficit EBIT Interest Profit before tax Tax Profit after tax Dividends Retained earnings Required: 140 90 35 15 80 40 20 5 15 1 16 4 12 2 10 2 8 (a) Prepare the classified cash flow statement for the period 1.20X7 (b) Develop the cash flow identity for the period 1.Adjustments for Interest paid Depreciation . in million) Profit & Loss Account for the Period 1.20X6 to 31.3.20X7 Solution : A.20X6 to 31.4.20X6 to 31.Net profit before tax and extraordinary items .Operating profit before working capital changes Adjustments for Inventories Debtors Trade creditors Provisions 11 4 5 20 (11) (1) 5 3 . Cash flow from operating activities .3.20X7 Net sales 220 Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Selling.The profit and loss account of Xavier Limited for the year 2007 is given below: (Rs.3.4.4.

Cash flow from assets .Cash flow before extraordinary items Extraordinary item . C.Cash generated from operations Income tax paid .03.Repayment of long term debt ..Dividends paid .03.Net cash flow from operating activities Cash flow from investing activities .Operating cash flow .Purchase of fixed assets . Cash flow from assets = = (B) + ( C) Cash flow to creditors + Cash flow to shareholders .Interest paid Net cash flow from financing activities Net increase in cash and cash equivalents .Decrease in net working capital .Cash flow from assets Cash flow to creditors .20X6 .20x7 (2) 14 (2) 12 1 13 (9) (9) C.Net new equity raised .Net cash flow from investing activities Cash flow from financing activities .Interest paid . Increase in other assets .Cash flow to shareholders 19 (9) (9) 1 4 5 9 2 (10) (8) We find that (A) i. 10 (5) (2) (4) (1) 3 5 8 D.e.Repayment of term loans -Dividend paid .Cash and cash equivalents as on 31. B.B.Cash flow to creditors Cash flow to shareholders .Increase in equity . Note (b) A It has been assumed that “other assets” represent “other current assets”.Cash and cash equivalents as on 31.Net capital spending .

6 So Total assets 0. What is the return on equity for Premier? Net profit Return on equity = Equity = Net profit x Net sales = Debt Note : Total assets = 0. What is the level of current liabilities? . debt to total assets ratio is 0.4 Equity = 1.0. Premier Company's net profit margin is 8 percent.2 1000 x 1. total assets turnover ratio is 2.4 = 0.5 or 50 per cent Net sales x Equity Total assets Solution: Hence Total assets/Equity = 1/0.08 x Total assets 1 2.7 300 The following information is given for Beta Corporation. The following information is given for Alpha Corporation Sales 3500 Current ratio 1.5 x 0.CHAPTER 4 1.2 Current liabilities 1000 What is the inventory turnover ratio? Solution: Current liabilities x 1.0 Current assets = = Quick assets = = Inventories = 3.2 = 1200 300 3500 Inventory turnover ratio = = 11.6 = 0.5 Acid test ratio 1.5 times.6.4 5 1.5 1000 x 1.5 = 1500 Current liabilities x 1. Sales Current ratio Inventory turnover ratio Acid test ratio 5000 1.4 2.

0 1000 = 1.4 Solution: PBT = Rs. If the company's times interest covered ratio is 4. what is the total interest charge? = 4 .40 million.Solution: Inventory = 5000/5 = 1000 Current assets Current ratio = Current liabilities Current assets – Inventories Acid test ratio = Current Liabilities C.A . what is the total interest charge? CL = 2500 CL 1000 = 1.interest = 3 x interest = 90 million Therefore interest = 90/3 = Rs.0 = 1.1000 = 1.0 CL CA CL 1.4 CL 1000 0.0 = 1. A has profit before tax of Rs.90 million.30 million 5. has profit before tax of Rs. If its times interest covered ratio is 6. Safari Inc.90 million PBIT Times interest covered = Interest So PBIT = 4 x Interest PBT = PBIT – interest = 4x interest.4 = CL 4.

000.63 million. = Rs. 40 million PBIT Times interest covered = Interest So PBIT = 6 x Interest PBIT – Interest = PBT = Rs.000.63 million PBIT Times interest covered = Interest So PBIT = 8 x Interest PBIT – Interest = PBT = Rs.000 Net profit margin = 5 per cent Net profit = Rs. 40 million 5 x Interest = Rs.9 million = 8 The following data applies to a firm : Interest charges Rs.40 million 6 x Interest – Interest = Rs.6.8 million 6.40 million = 6 Hence Interest = Rs.000 Sales Rs.200.6. If the company's times interest covered ratio is 8. what is the total interest charge? Solution: PBT = Rs. has profit before tax of Rs.05 = 300. McGill Inc.6.000.Solution: PBT = Rs.000 Tax rate 40 percent Net profit margin 5 percent What is the firm's times interest covered ratio? Solution: Sales = Rs.63 million Hence Interest 7.000 Tax rate = 40 per cent .000 x 0.63 million 8 x Interest – Interest = 7 x Interest = Rs.

000 What is the firm's times interest covered ratio? . The following data applies to a firm: Interest charges Sales Tax rate Net profit margin Rs.200.500.24 50.10.000 Rs.03 = 9.000 = 3.50.000 50 percent 10 percent So Profit before interest and taxes = Rs.25) Interest charge = Rs.12.62.300. The following data applies to a firm : Interest charges Sales Tax rate Net profit margin Rs.80. Profit before tax = (1-. = 25 per cent 9.50.000 Net profit margin = 3 per cent Net profit = Rs.000.000 25 percent 3 percent What is the firm's times interest covered ratio? Solution: Sales = Rs.300.000 Tax rate So.000 9.000 Profit before tax = (1-.000 So Profit before interest and taxes = Rs.000 So.000 Hence Times interest covered ratio = = Rs.300.000 8.000 62.700.000 Hence Times interest covered ratio = 700.000 Rs.000.000 x 0.000 = 1.4) Interest charge = Rs.5 200.000 = Rs.300.

000 Let BB stand for bank borrowing .000 So Profit before interest and taxes = Rs.000 + BB 0.Solution: Sales = Rs.000.000 respectively.35 1.33? 1.000 + 1.000.000 Let BB stand for bank borrowing CA+BB = CL+BB 25.35 = 2.35? Solution: CA = 25.000 Tax rate = 50 per cent 8.000 and 140.1 = 8.26.5) Interest charge = Rs.35x 18.35 Solution: CA = 200. How much additional funds can it borrow from banks for short term.24.35BB = 25. without reducing the current ratio below 1.16.000.000 So.000 Times interest covered ratio = = 2.000 respectively.10.000 x 0.000.000.000.300 = 700 BB = 700/0.000+BB 1. without reducing the current ratio below 1.000 CL = 140. Profit before tax = = Rs.000 CL = 18.000.35 BB = 25.000 11.000+BB = 18.000 Hence 26.80.000 10.000 (1-. LNG’s current assets and current liabilities are 200.6 10. How much additional funds can it borrow from banks for short term. A firm's current assets and current liabilities are 25.000.80.000 Net profit margin = 10 per cent Net profit = Rs.000.000 and 18.000.

without reducing the current ratio below 1.000..33 x 140.6 days 68.000.000.000.000.000.9.000 BB = 200.000.000.000. How rapidly (in how many days) must accounts receivable be collected if management wants to reduce the accounts receivable to 6.800 BB =13.33 1.000.000 + BB 0.000.000 = 200.000? 1. A firm has total annual sales (all credit) of 25.000 Let BB stand for bank borrowing Solution: 25.000 the ACP must be: 6.4 x 7.33 1.000 Average daily credit sales = = 68.000+BB 1.33 = 41.800/0.4? Solution: CA = 10.4 BB = 10.000/0.000 = 87.818 12.200 = 13.000.33 BB = 200.CA+BB = CL+BB 200.000 + 1.000.4BB = 10.000 + 1.000 + BB 0.000.000+BB 1.800.000 13.000 and accounts receivable of 8.000+BB = 7.493 .493 365 If the accounts receivable has to be reduced to 6.000 and 7.000.186.000.4 1. Navneet’s current assets and current liabilities are 10.33BB = 200.000+BB = 140.4 CL = 7.000. How much additional funds can it borrow from banks for short term.000.000 respectively.000 CA+BB = CL+BB 10.40 = 500.

000.6 16.000.000 = 91.000? = 3287. A firm has total annual sales (all credit) of 1.000. A firm has total annual sales (all credit) of 100.000.67 Solution: 100. How rapidly (in how many days) must accounts receivable be collected if management wants to reduce the accounts receivable to 15.200.14.000 and accounts receivable of 500.000.000 Average daily credit sales = 365 If the accounts receivable has to be reduced to 15.000.25 = 2500 Current assets .000.972.67 15.200.972.000 and accounts receivable of 20. The financial ratios of a firm are as follows. Current ratio Acid-test ratio Current liabilities Inventory turnover ratio What is the sales of the firm? = = = = 1.Inventories = Current liabilities x Acid test ratio = 2000 x 1.000 Average daily credit sales = 365 If the accounts receivable has to be reduced to 300.3 days 3287.10 = 2200 Inventories = 300 Sales = = Inventories 300 x Inventory turnover ratio x 10 = 3000 .000 = 54.000? Solution: 1.000 the ACP must be: 15.6 Solution: Current assets = Current liabilities x Current ratio = 2000 x 1.10 2000 10 = 273. How rapidly (in how many days) must accounts receivable be collected if management wants to reduce the accounts receivable to 300.25 1.8 days 273.000 the ACP must be: 300.000.

6 1.200 x 6 = 127.000.17.200.000 Inventories Sales = = = 21.000 Inventories x Inventory turnover ratio 800.000.000 Current assets . Current ratio = Acid-test ratio = Current liabilities = Inventory turnover ratio = What is the sales of the firm? 1.Inventories = Current liabilities x = 2.2 = 2.Inventories = Current liabilities x Acid test ratio = 40.000 5 Solution: Current assets = Current liabilities x Current ratio = 2.000. The financial ratios of a firm are as follows.000 .000 x 0.000 6 Solution: Current assets = Current liabilities x Current ratio = 40.000 Acid test ratio 1.200 18.200 Current assets .000 x 1.2 2. The financial ratios of a firm are as follows.200 Inventories x Inventory turnover ratio 21.000 x 1.6 = 3.000.000 x Inventories Sales = = = 800.400.80 = 32.80 40.000 x 5 = 4.33 0. Current ratio Acid-test ratio Current liabilities Inventory turnover ratio What is the sales of the firm? = = = = 1.33 = 53.

80 Equity = 80..000 Hence Total assets = 130.80 1. …….. . .000 Total assets turnover ratio = 2 So Sales = 2 x 234.000 Short-term bank borrowings .19.600 = 6 x 30 = 39.000 = 360 Cost of goods sold Inventory turnover ratio = Inventory = Inventory 327.000 x 30 = 104..8 x 130. ...7 x 468. ...000 Gross profit margin = 30 per cent So Cost of goods sold = 0...... .000 Retained earnings 50.000+104.. .000 = 327. Sales Cost of goods sold Solution: Debt/equity = 0. ...600 Day’s sales outstanding in accounts receivable = 30 days Sales So Accounts receivable = 360 468....000 = 234. .000 = 468..000 + 50.1 2 30 days 30 percent 6 Balance sheet Equity capital 80..000 = 130.000 So Debt = Short-term bank borrowings = 0.. ..000 . Complete the balance sheet and sales financial data: Debt/equity ratio Acid-test ratio Total assets turnover ratio Days' sales outstanding in Accounts receivable Gross profit margin Inventory turnover ratio data (fill in the blanks) using the following = = = = = = 0. Plant and equipment Inventories Accounts receivable Cash .

..000 Plant & equipment Inventories Accounts receivable Cash 65. Cash .000 ..600 .000 Short-term bank borrowings 104.000 Short-term bank borrowings ..000 – 75..So Inventory = 54.. …… . 468.000 = 104 .000..000 54.000 Retained earnings 50.Inventories – Accounts receivable – Cash = 234. .600 39..400 = 65.000.. .40 Acid-test ratio = 0.. .400 234.9 Total assets turnover ratio = 2.000 327.39.000 Retained earnings 30. Sales Cost of goods sold .600 As short-term bank borrowing is a current liability. .000 Sales Cost of goods sold 20.54.000 Putting together everything we get Balance Sheet Equity capital 80.. …….5 Days' sales outstanding in Accounts receivable = 25 days Gross profit margin = 25 percent Inventory turnover ratio = 8 Balance sheet Equity capital 160.000 75.000 = 1..000 So Cash = 75.600 Complete the balance sheet and sales data (fill in the blanks) using the following financial data: Debt/equity ratio = 0. . Plant and equipment-------Inventories ……… Accounts receivable ….400 Plant and equipment = Total assets .1 234.….. .. Cash + Accounts receivable Acid-test ratio = Current liabilities Cash + 39.

750.000.000 266.000.000 So Cash = 22.000 76.750 .000 .000.180.000.000.444 Plant and equipment = Total assets .000 498.000 Gross profit margin = 25 per cent So Cost of goods sold = 0.4 x 190.750 As short-term bank borrowings is a current liability.5 So Sales = 2.000 = 266.62.343.556 = = 0.Solution: Debt/equity = 0.750 Accounts receivable 46. Cash + Accounts receivable Acid-test ratio = Current liability Cash + 46.250 Inventories 62.Inventories – Accounts receivable – Cash = 266.180.180.000.444 266.000.556 Cash 22.000.000 30.750.75 x 665.000 = 190.46.000 Hence Total assets = 190.000.250 Putting together everything we get Balance Sheet Equity capital Retained earnings Short-term bank borrowings 160.000.343.40 Equity = 160.000.000.000.000.000 .000 = 8 Sales Cost of goods sold .000.000 Plant & equipment 135.000 = 498.000 = 665.000 665.343.556 – 22.5 x 266.000 Day’s sales outstanding in accounts receivable = 25 days Sales So Accounts receivable = x 25 360 665.000 = = 46.444 = 135.000 Total assets turnover ratio = 2.000+ 76.556 498.000 = Inventory = 76.000.219.000 + 30.9 76.219.000 So Debt = Short-term bank borrowings = 0.000.219.180.256.000 x 25 360 Cost of goods sold Inventory turnover ratio = Inventory So Inventory = 62.256.750.000.000.

. .394.000 Inventory turnover ratio = So Inventory = 342..903 360 Cost of goods sold 2. Complete the balance sheet and sales data (fill in the blanks) using the following financial data: Debt/equity ratio Acid-test ratio Total assets turnover ratio Days' sales outstanding in Accounts receivable Gross profit margin Inventory turnover ratio = 1.000 = 1.394.5 x 700.000 Short-term bank borrowings .000 = 3.000 Hence Total assets = 700. ...21..9 = 25 days = 28 percent = 7 Balance sheet Equity capital 600. . .325.000+1050.000 x 25 = 230..000 = = 7 Inventory Inventory x 25 = 1050.. .325.5 = 0...000 Day’s sales outstanding in accounts receivable = 25 days Sales So Accounts receivable = 360 = 3.000 Total assets turnover ratio = 1..9 x 1.. Sales Cost of goods sold Solution: Debt/equity = 1.000 + 100. ……… Equity = 600.5 . ….000 = 2. ..9 So Sales = 1.750.000 So Debt = Short-term bank borrowings =1.... ..000 = 700..72 x 3.3 = 1.000 Gross profit margin = 28 per cent So Cost of goods sold = 0. Plant and equipment Inventories Accounts receivable Cash ... .325.750.000 .000 Retained earnings 100. .

325.3 1.110.000 – 230.000.000. 3. Evaluate Acme's performance with reference to the standards. Acme Limited Balance Sheet.000 30.000 So Cash = 84.903 Cash 84.000 Sales Cost of goods sold 22.000 Plant &equipment 1.000.60.000.000.000.097 Plant and equipment = Total assets .000 45.394.000.097 1.750.000 = 0.093.000 45.As short-term bank borrowings is a current liability . 20X7 Liabilities and Equity Equity capital Reserves and surplus Long-term debt Short-term bank borrowing Trade creditors Provisions Total Assets Fixed assets (net) Current assets Cash and bank Receivables Rs.000 2.000.000 30.000 .000 Putting together everything we get Balance Sheet Equity capital 600.000 Rs.903 = 1050 .000 Short-term bank borrowings 1050.000 Accounts receivable 230.903 – 84.Inventories – Accounts receivable – Cash = 1. March 31.000 72.000 Compute the financial ratios for Acme Ltd.000 – 342.000 40.000 15.750.000 Inventories 342.097 = 1.750.000.000. Cash + Accounts receivable Acid-test ratio = Current liabilities Cash + 230.000 Retained earnings 100.093.000 62.

000 66.000 50.000.000 70.5 5.000 204.000 10.000 116.3 0.000.000 45.000 20.000.000 72.5 8% 20 % 18 % .Inventories Pre-paid expenses Others Total 61.000 Standard 1.000 38.000.000.000 34.000 4.000 .000.000 217.000.000.000.000.000 58.70 2.000. Let assume that ‘Others’ in the balance sheet represents other current assets.0 4.000 12.000 4.320.000.000.000.000 6. Liabilities and Equity Equity capital Reserves and surplus Long-term debt Short-term bank borrowing Total Rs.000.000. we may recast the balance sheet as under.000.000.0 45 days 1. 20X7 Net sales Cost of goods sold Gross profit Operating expenses Operating profit Non-operating surplus Profit before interest and tax Interest Profit before tax Tax Profit after tax Dividends Retained earnings Acme Current ratio Acid-test ratio Debt-equity ratio Times interest covered ratio Inventory turnover ratio Average collection period Total assets turnover ratio Net profit margin ratio Earning power Return on equity Solution: For purposes of ratio analysis.000.000.000.000 262.000 40.60.000 Acme Limited Profit and Loss Account for the Year Ended March 31.000.

000.1 = 110.000.000 = Current liabilities 85.000.000.000 + 40.000.000 Pre-paid expenses 10.000.000 = 1.000.000 45.000.000 Less: Current liabilities Trade creditors 30.000 Inventories 61.000 = 60.000 = 1.8 85.000 152.000.000 204.000.000 = 3.000 107.000 217.000.000 + 45.000 (Current liabilities here includes short-term bank borrowing also) Long-term debt + Short-term bank borrowing (iii) Debt-equity ratio = Equity capital + Reserves & surplus 72.000.000.000 Net current assets Total Current assets (i) Current ratio = Current liabilities 152.000 Receivables 45.000.1 .000 Others 6.000.34 = 5.83 = 1.000.000.000 Cost of goods sold (v) Inventory turnover period = Inventory = 61.000.000.000 Profit before interest and tax (iv) Times interest coverage ratio = Interest 70.000.000.000 Provisions 15.000 = 12.000.Assets Fixed assets (net) Current assets Cash and bank 30.000.000 (Current liabilities here includes short-term bank borrowing also) Current assets – Inventories (ii) Acid-test ratio = 91.000.

000.3 51.000 = 11.2 % 70.000 = 36.000 38.3 0.000 Net sales 320.2 % Standard 1.000 38.000.3 days 1.0 45 days 1.9% = 1. .5 11.1 5.000) = 217.000. Compute the financial ratios for Nainar Ltd.8 3.365 (vi) Average collection period = Net sales / Accounts receivable 365 = = 51.3 days 320.1 1.5 8% 20 % 18 % 23.000.000.000+40.000.000/45.000.000.000.000 ) +(72.000 Profit after tax (ix) Net profit margin = Net sales PBIT (x) Earning power = Total assets = 217.000.5 5.0 4.000.000 + 45.3 % 36.000 = 32.000 (vii) Total assets =Equity + Total debt =( 60.000 = Net worth 105.000. Evaluate Nainar's performance with reference to the standards.5 Equity earning (xi) Return on equity = The comparison of the Acme’s ratios with the standard is given below Current ratio Acid-test ratio Debt-equity ratio Times interest covered ratio Inventory turnover ratio Average collection period Total assets turnover ratio Net profit margin ratio Earning power Return on equity Acme 1.000.000 Total assets turnover ratio = = Total assets 217.000.000.8 1.7 2.9 % 32.3 % = 320.

000. 20X7 .000.000 12.000 24.000 85.000 62.000 20.000 Standard 1.000.000 140.000.000 118.000.000.000.000 65.0 8% 30 % 35 % Nainar Limited Profit and Loss Account for the Year Ended March 31.000 102.000.000.4 5.000.000 418.000 520.0 40 days 2.206.000 46.000.000.000 70.000 Rs.000 418.000 108.000.000.000.000 Rs.000 12.000 70.000.000 19.000.000 25.000 22. 20X7 Liabilities and Equity Equity capital Reserves and surplus Long-term debt Short-term bank borrowing Trade creditors Provisions Total Assets Fixed assets (net) Current assets Cash and bank Receivables Inventories Pre-paid expenses Others Total Net sales Cost of goods sold Gross profit Operating expenses Operating profit Non-operating surplus Profit before interest and tax Interest Profit before tax Tax Profit after tax Dividends Retained earnings Nainar Current ratio Acid-test ratio Debt-equity ratio Times interest covered ratio Inventory turnover ratio Average collection period Total assets turnover ratio Net profit margin ratio Earning power Return on equity Rs.000.Nainar Limited Balance Sheet.7 1.000 20.100.740.000.000. March 31.000.000 42.0 1.000.000 130.000.000.5 6.000.000 220.000.000.

000.000 ( Current liabilities here includes short-term bank borrowing also) Current assets – Inventories (ii) Acid-test ratio = 127.000 70.000 169. Let assume that ‘Others’ in the balance sheet represents other current assets.000 19.000 24.000.000 = 1.000 206.000.000 12.000 65.000.000.000.000.1 = = Current liabilities 113.000.9 113.000.000 Total 43.000 = 1.000 ( Current liabilities here includes short-term bank borrowing also) Long-term debt + Short-term bank borrowing (iii) Debt-equity ratio = Equity capital + Reserves & surplus .000.000.000 85.000 20.000.000.000 25.000.000 Current assets (i) Current ratio = Current liabilities 212.000 375.000.Solution: For purposes of ratio analysis.000 140.000.000. we may recast the balance sheet as under.000.000 375. Liabilities and Equity Equity capital Reserves and surplus Long-term debt Short-term bank borrowing Total Assets Fixed assets (net) Current assets Cash and bank Receivables Inventories Pre-paid expenses Others Less: Current liabilities Trade creditors Provisions Net current assets 100.000.000 70.000 212.000.000.

000.000 + 65.000.000.000 + 70.000 = 375.000 + 65.000.000.5 days 740.000.000.000 = 34.4 % 740.000.000.000.000) = 375.000.000.000 = 8.000 = 22.000.000 = 6.000 (vii) Total assets = Equity + Total debt =(100.0 = 85.000.000 Profit before interest and tax (iv) Times interest coverage ratio = Interest 130.7 % = 740.000.000 = 2.000.6 % 130.9 Equity earning (xi) Return on equity = The comparison of the Nainar’s ratios with the standard is given below .000 Net sales Total assets turnover ratio = Total assets Profit after tax (ix) Net profit margin = Net sales PBIT (x) Earning power = Total assets = 375.000.1 = 5.3 100.000.140.000 520.000.000.000 62.000.000.000 62.000 ) +(140.000 = = 1.000/70.000+70.000.000 = Net worth 165.000 Cost of goods sold (v) Inventory turnover period = Inventory 365 (vi) Average collection period = Net sales / Accounts receivable 365 = = 34.000 = 37.

4 2.1 6.8 20X7 2 3 1.8 9.8 2.8 1.6 % Standard 1.5 6.7 1.2 2.7 1.3 6.5 1.3 2.1 2.7 9. Nalvar Limited (Rs. are given below: Comparative Balance Sheets.5 20X5 1.4 1.2 2 0.8 1.8 1.4 0.8 9.3 2.5 1.8 1.9 6.4 2 0.6 1.5 2.5 1.3 1.6 1.9 1.2 20X6 1.5 7.4 1.8 1.4 20X4 1.4 1.0 1.5 2.6 1.3 1.4 Share capital Reserves and surplus Long-term debt Short-term bank borrowing Current liabilities Total Assets Net fixed assets Current assets Cash and bank Receivables Inventories Other assets Total .2 1.8 2.5 9.0 40 days 2.0 8.2 0.8 1.5 1.6 1.0 1.4 1. The comparative balance sheets and comparative Profit and Loss accounts for Nalvar Limited.3 1.4 5.7 0.7 % 37.Nainar Current ratio Acid-test ratio Debt-equity ratio Times interest covered ratio Inventory turnover ratio Average collection period Total assets turnover ratio Net profit margin ratio Earning power Return on equity 1.0 8% 30 % 35 % 24.4 % 34.4 2. in million) 20X3 1.9 8.6 8.4 1.5 days 2.2 1.1 34.1 1.3 5.3 7.

7 0.7 2 Current assets Cash and bank 0. You may assume that other assets in the balance sheet represent other current assets.3 6.2 0.6 2.9 1 -0.9 1.6 1.2 0.2 3.4 Short-term bank borrowing 1.3 0.85 20X4 4.4 Required: Compute the important ratios for Nalvar Limited for the years 20X3-20X7.6 1.1 2.6 1.9 0.9 0.3 2.8 2.1 20X6 6.3 0.2 Total 5.1 1.1 0.Comparative Profit and Loss Accounts.4 1 0.6 Assets Net fixed assets 1.4 .9 0.5 4 2.8 1.2 7.3 2.5 1.8 3 0.2 7.8 2 Reserves and surplus 1 1.1 1.3 3 Long-term debt 1.1 0.5 0.5 1.7 1.6 1.2 0.4 2 1.2 1.3 0.82 20X5 5. It is assumed that ‘Other assets’ are other current assets Liabilities and Equity 20X3 20X4 20X5 20X6 20X7 Share capital 1.1 2.7 7.3 1. • Current ratio • Debt-equity ratio • Total assets turnover ratio • Net profit margin • Earning power • Return on equity Solution: We will rearrange the balance sheets as under for ratio analysis.6 2.4 1.5 2.1 1.8 2.2 1 0.1 0.9 20X7 7.3 0.4 0. Nalvar Limited (Rs.1 0.8 4.1 2.2 0.9 0.6 1. in million) Net sales Cost of goods sold Gross profit Operating expenses Operating profit Non-operating surplus deficit Profit before interest and tax Interest Profit before tax Tax Profit after tax 20X3 3.5 1.4 Receivables 2.6 1.1 1 0.5 1.05 0.4 2.4 0.2 0.8 0.3 3.3 0.2 1.8 1.08 0.

are given below: Comparative Balance Sheets.3 1.1 5.8 1.7 26.2 1.9 18.Inventories Other current assets Less: Current liabilities Other current liabilities Net current assets Total 1.6 -2.3 2.2 The required ratios are as under: • • • • • • Current ratio Debt-equity ratio Total assets turnover ratio Net profit margin(%) Earning power (%) Return on equity (%) 20X3 20X4 20X5 20X6 20X7 2.3 1.5 7.8 5.2 1.9 1.3 2.2 2.2 1.9 0.2 2.6 5.5 1.7 0.8 1.6 35.5 1.5 -1.1 5.9 1.7 2.8 7.4 22.7 0.8 17.0 32.1 14.5 4.4 19.7 7.9 16.1 2.8 0.1 1.6 7.8 1. a machine tool manufacturer.3 6.1 4. Somani Limited (Rs.7 7.3 2. in million) Share capital Reserves and surplus Long-term debt Short-term bank borrowing Current liabilities Total Assets Net fixed assets Current assets Cash and bank Receivables Inventories Other Assets Total 20X3 20X4 20X5 20X6 41 50 50 50 16 36 72 118 28 25 30 29 35 30 36 38 24 28 30 30 144 169 218 265 72 8 24 35 5 144 80 9 30 42 8 169 75 15 59 55 14 218 102 12 62 75 14 265 20X7 55 150 22 38 25 290 103 11 85 79 12 290 .0 0.5 5.2 2.4 1.8 0.8 6.3 30. The comparative balance sheets and comparative Profit and Loss accounts for Somani Limited.5 25.6 1.4 1.0 28.8 1.5 0.7 0.0 22.9 13.6 7.

we will rearrange the balance sheet as under. It is assumed that ‘Other assets’ are other current assets 20X3 20X4 20X5 20X6 20X7 Share capital 41 50 50 50 55 Reserves and surplus 16 36 72 118 150 Long-term debt 28 25 30 29 22 Short-term bank borrowing 35 30 36 38 38 120 141 188 235 265 Total Assets Net fixed assets Current assets Cash and bank Receivables Inventories Other assets Less : Current liabilities Net current assets Total 72 8 24 35 5 24 9 30 42 8 28 80 15 59 55 14 30 75 12 62 75 14 30 102 11 85 79 163 12 30 25 133 235 103 72 24 48 120 89 28 61 141 143 30 113 188 187 25 162 265 . in million) 20X3 20X4 20X5 285 320 360 164 150 170 121 170 190 64 66 68 57 104 122 3 4 4 60 108 126 8 6 10 52 102 116 15 26 30 37 76 86 20X6 350 175 175 68 107 3 110 12 98 26 72 20X7 355 174 181 64 117 3 120 12 108 29 79 Net sales Cost of goods sold Gross profit Operating expenses Operating profit Non-operating surplus deficit Profit before interest and tax Interest Profit before tax Tax Profit after tax Compute the following ratios for years 20X3-20X7: • Current ratio • Debt-equity ratio • Total assets turnover ratio • Net profit margin • Earning power • Return on equity For ratio analysis purpose.Comparative Profit & Loss Account of Somani Ltd (Rs.

8 23. The Balance sheets and Profit and Loss accounts of LKG Corporation are given below.3 2.9 88.5 2. Prepare the common size and common base financial statements Balance Sheets Shareholders’ funds Loan funds Total Fixed assets Investments Net current assets Total (Rs.6 22.0 23.3 64.5 42.4 3.9 1.3 13.The ratios worked out are as under: 20X3 20X4 20X5 20X6 20X7 1.6 0.1 0.4 0.9 38.2 2.0 1.6 67.0 46. in million) 20x6 20x7 623 701 475 552 148 149 105 89 22 21 83 68 41 34 42 34 Net sales Cost of goods sold Gross profit PBIT Interest PBT Tax PAT .4 70.0 76.5 0.3 1.4 2.5 • • • • • • Current ratio Debt-equity ratio Total assets turnover ratio Net profit margin (%) Earning power (%) Return on equity (%) 26.9 20.2 1.8 45.3 50.5 1. in million) 20x6 20x7 256 262 156 212 412 474 322 330 15 15 75 129 412 474 Profit & Loss Accounts (Rs.

Prepare the common size and common base financial statements Balance Sheet Shareholders’ fund Loan funds Total Fixed assets Investments Net current assets Total 20x6 85 125 210 127 8 75 210 20x7 85 180 265 170 10 85 265 . 256 156 412 322 15 75 412 262 212 474 330 15 129 474 Common Size(%) 20x6 20x7 62 38 100 78 4 18 100 55 45 100 70 3 27 100 The Balance sheets and Profit and Loss accounts of Grand Limited are given below.Solution: Common Size statements: Profit and Loss Account Regular ( in Rs. million) Net sales Cost of goods sold Gross profit PBIT Interest PBT Tax PAT 20x6 623 475 148 105 22 83 41 42 20x7 701 552 149 89 21 68 34 34 Common Size(%) 20x6 100 76 24 17 4 13 7 7 20x7 100 79 21 13 3 10 5 5 Balance Sheet Regular ( in million) 20x6 20x7 Shareholders' funds Loan funds Total Fixed assets Investments Net current assets Total 27.

in million) 20x7 20x6 85 125 210 127 8 75 210 85 180 265 170 10 85 265 20x7 560 410 150 98 17 81 38 43 Balance Sheet Shareholders' funds Loan funds Total Fixed assets Investments Net current assets Total Profit & Loss Account Net sales Cost of goods sold Gross profit PBIT Interest PBT Tax PAT Common Size(%) 20x6 20x7 40 60 100 60 4 36 100 32 68 100 64 4 32 100 Regular (Rs.Profit & Loss Account 20x6 Net sales 450 Cost of goods sold 320 Gross profit 130 PBIT 85 Interest 12 PBT 73 Tax 22 PAT 51 Solution: Regular (Rs. in million) 20x6 20x7 450 560 320 410 130 150 85 98 12 17 73 81 22 38 51 43 Common Size(%) 20x6 20x7 100 100 71 73 29 27 19 18 3 3 16 14 5 7 11 8 .

in million) 20x6 20x7 450 560 320 410 130 150 85 98 12 17 73 81 22 38 51 43 Common base year (%) 20x6 20x7 100 124 100 128 100 115 100 115 100 142 100 111 100 173 100 84 Profit & Loss Account Net sales Cost of goods sold Gross profit PBIT Interest PBT Tax PAT CHAPTER 5 1. The profit and loss account of Sasi Industires Limited for years 1 and 2 is given below: Using the percent of sales method. prepare the pro forma profit and loss account for year 3. what amount of retained earnings can be expected for year 3? Year Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus deficit 1 2300 1760 540 150 120 94 176 12 2 2700 2000 700 180 124 84 312 10 .Common base year statements Regular (Rs. in Common base year Balance Sheet million) (%) 20x6 20x7 20x6 20x7 100 Shareholders' funds 85 85 100 Loan funds 125 180 100 144 Total 210 265 100 126 Fixed assets 127 170 100 134 Investments 8 10 100 125 Net current assets 75 85 100 113 Total 210 265 100 126 Regular (Rs. Assume that the sales will be 3500 in year 3. If dividends are raised to 40.

45 10.00 5.46 Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus deficit Earnings before interest and tax Interest Earnings before tax Tax Earnings after tax Dividends(given) Retained earnings 2300 1760 540 150 120 94 176 12 188 30 158 56 102 35 67 2700 2000 700 180 124 84 312 10 322 38 284 96 188 35 153 100 75.29 104.75 47.36 8.14 15.05 1.46 304.46 40 159.59 4.43 864.80 171.83 199.Earnings before interest and tax Interest Earnings before tax Tax Earnings after tax Dividends Retained earnings Solution: Year 188 30 158 56 102 35 67 322 38 284 96 188 35 153 1 2 Average percent of sales Proforma Profit & Loss account for year 3 assuming sales of 3500 3500 2635.97 336.60 9.70 .90 3.30 24.67 125.60 0.70 6.57 230.69 3.61 351.

000 26000 18738.86 15.2.93 4.460 16100 6360 890 Average percent of sales 100 72.98 7261.230 13. The profit and loss account of KG Electronics Limited for years 1 and 2 is given below: Using the percent of sales method.07 27.98 1.000 in year 3. Year Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus deficit Earnings before interest and tax Interest Earnings before tax Tax Earnings after tax Dividends(given) Retained earnings 1 18.09 4121.95 . If dividends are raised to 500. prepare the pro forma profit and loss account for year 3.210 5020 820 1200 382 2618 132 2750 682 2068 780 1288 320 968 2 22.230 13. Assume that the sales will be 26. what amount of retained earnings can be expected for year3 .85 1556.210 5020 820 2 22.460 16100 6360 890 1210 364 3896 82 3978 890 3088 980 2108 450 1658 Solution: Year Proforma Profit & Loss account for year 3 assuming sales of 26.89 Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit 1 18.23 1200 382 2618 1210 364 3896 5.09 483.02 1099.

85 12.05 Budgeted 8.00 304.43 864.40 3.00 125.700 2000 700 180 124 84 312 10 322 38 284 96 188 35 153 .70 Budgeted Budgeted 3.61 Re-work problem 1 assuming the following budgeted amounts: General and administration expenses 135 Selling expenses 200 Interest 42 Dividends 40 Solution: Year Average percent of sales 100 75.54 16.46 40 159.Non-operating surplus deficit Earnings before interest and tax Interest Earnings before tax Tax Earnings after tax Dividends(given) Retained earnings 3.61 500 1638.500 3500 2635.75 42.83 199.23 141.00 5.48 3262.60 9.32 8.59 4263.69 3.29 104.55 4.70 Budgeted Proforma Profit & Loss account for year 3 assuming sales of 3.30 24.46 2138.97 336.61 351.07 1123.14 15.00 135.57 200.46 Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus deficit Earnings before interest and tax Interest Earnings before tax Tax Earnings after tax Dividends(given) Retained earnings 1 2300 1760 540 150 120 94 176 12 188 30 158 56 102 35 67 2 2.60 0.45 10. 132 2750 682 2068 780 1288 320 968 82 3978 890 3088 980 2108 450 1658 0.55 1001.

59 4263.95 141.98 7261.460 16100 6360 890 1200 382 2618 132 2750 682 2068 780 1288 320 968 1210 364 3896 82 3978 890 3088 980 2108 450 1658 Budgeted Budgeted 15.07 27.55 4. For the year 2008 .54 16.23 Budgeted 1620.93 4.55 120.23 Proforma Profit & Loss account for year 3 assuming sales of 26.00 3262.02 1099.46 2138.89 Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus deficit Earnings before interest and tax Interest Earnings before tax Tax Earnings after tax Dividends(given) Retained earnings 5.230 13.00 4121. 1 18.4.40 Budgeted 12.07 1123. the following are the budgeted figures.000 26000 18738.85 0. Sales 3000 General and Administration expenses 150 Depreciation 100 Non operating surplus 80 Dividend 50 .00 520.32 8.61 560 1578.210 5020 820 2 22.61 The profit and loss account and balance sheet for the years 2006 and 2007 of Radiant Corporation are as under. Re-work problem 2 assuming the following budgeted amounts: General and administration expenses 1620 Depreciation 520 Interest 120 Dividends 560 Solution: Year Average percent of sales 100 72.

All other figures both in the proforma profit and loss account as well as balance sheet. will change in proportion to the average its proportion to sales of that year for the past two years.700 2000 700 180 124 84 312 10 322 38 284 96 188 35 153 Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus deficit Earnings before interest and tax Interest Earnings before tax Tax Earnings after tax Dividends(given) Retained earnings Balance Sheets Fixed assets (net Investments Current assets. It is also assumed that any extra funds needed to achieve the desired financial position for 2008 will be raised by way of debentures. Year 2006 2300 1760 540 150 120 94 176 12 188 30 158 56 102 35 67 2007 2. secured bank borrowings and miscellaneous expenditure and losses. loans and advances · Cash and bank · Receivables · Inventories · Pre-paid expenses Year 2006 2007 1460 1520 75 90 61 438 620 78 58 510 710 84 .Investments 110 Pre-paid expenses 80 Unsecured bank borrowings 100 There will be no change in the levels of share capital. Prepare the proforma financial statements for the year 2008 using the excel model given in the text.

0 744.0 Before After iteration iteration Proforma Proforma profit profit and loss and loss account account for 2008 for 2008 3000.5 272 96 Average percent of sales Projected 100.700 2000 700 180 124 84 312 70 382 82.0 150.2 @ 3.0 376.0 198.2 24.8 6.0Budgeted 75.Miscellaneous expenditures losses Total Liabilities Share capital Equity Preference Reserves and surplus Secured loans Debentures Bank borrowings Unsecured loans Bank borrowings Current liabilities and provision Trade creditors Provisions Total Solution: & 38 2770 42 3014 540 80 460 690 580 120 540 80 527 642 625 200 200 100 2770 320 80 3014 Year Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus deficit Earnings before interest and tax Interest on bank borrowings Interest on debentures Earnings before tax Tax 2006 2300 1760 540 150 120 94 176 50 226 77 30 119 56 2007 2.0 100.0 95.0 198.0 80.0 80.0 376.7 91.7 27.2 .6 Budgeted Budgeted @ Budgeted @ 3.0 2256.0 296.6 252.8 199.0 296.0 3000.7 95.0 2256.5 80.0 150.2 91.0 100.0 744.5 27.

1 million .1 59.0 3519.0 3519.Earnings after tax Dividends(given) Retained earnings Balance Sheets Fixed assets (net Investments Current assets. loans and advances · Cash and bank · Receivables · Inventories · Pre-paid expenses Miscellaneous expenditures & losses Total Liabilities Share capital Equity Preference Reserves and surplus Secured loans Debentures Bank borrowings Unsecured loans Bank borrowings Current liabilities and provisions Trade creditors Provisions Total 6.0 80.0 110.5 1788. and d = 0.0 80.4 540 80 910 240 580 120 200 100 2770 540 80 1051 220 625 200 320 80 3116 10.0 42.0 312. L/S = 0.0 110.6 1788.@ 0.0 80.0 80.Budgeted 252.0 312.3 x 50 . 119 35 28 2006 1460 75 272 35 141 2007 1520 90 @ Budgeted . S = Rs.8 625.0 61 438 620 78 38 2770 58 612 710 84 42 3116 2.6 . m = 0.0 100.0 108.4 630.4 No change Budgeted The following information is available for ABC Limited : A/S = 0.6 No change No change @ 540. What is the external funds requirement for the forthcoming year? Solution: The external funds requirement of Olympus is: EFR = A*/S0 (∆S) – L*/S (∆S) – mS1 (r) = 0.4 540.0 199. S1 = Rs.4 3.4 71.6 591.8 50.30.Budgeted No change 71.0 58.6.0 111.4 21.0 108.0 798.350 million.0 26..300 million.0 3519.0 3519.0 1162.0 1109.5 644.6 x 50 – 0.0 42.0 798.7 50.5.08.9 625.5 = Rs.08 x 350 x 0.6 .0 100.4 630.

L/S = 0.. 2008.2 x 20 . Vasundhara Corporation expects its sales to increase by 40 percent in the year ending March 31. The balance sheet of Vasundhara Corporation as at March 31.35 million.6.4 = Rs.800. S1 = Rs. The following information is available for XYZ Limited : A/S = 0.04.5 x 20 – 0. 2007 were 2. S = Rs. . The ratio of assets to sales and spontaneous current liabilities to sales would remain unchanged.04 x 55 x 0. Estimate the external funds requirement for the year 2008. and the dividend payout ratio would remain unchanged.5.20. Its profit margin on sales was 8 percent and its dividend payout ratio was 30 percent.55 million. Prepare the following statements. m = 0.5. What is the external funds requirement for the forthcoming year? Solution: The external funds requirement of Olympus is: EFR = A*/S0 (∆S) – L*/S (∆S) – mS1 (r) = 0. Likewise the profit margin ratio. the tax rate. Required: a. assuming that the external funds requirement would be raised equally from term loans and shortterm bank borrowings: (i) projected balance sheet and (ii) projected profit and loss account. The tax rate was 40 percent.12 million 8. 2007 is shown below: Share capital 500 Fixed assets 750 Retained Earnings 120 Inventories 400 Term Loans 360 Receivables 330 Short-term Bank Borrowings 300 Cash 90 Accounts Payable 210 Provisions 80 1570 1570 The sales of the firm for the year ending on March 31. and d = 0. b.7.

292 b.920 523 209 314 94 220 2198 .08 x 3920 (1-0. (i) Projected Income Statement for Year Ending 31st March .Solution: a A EFR = S 1570 = 2800 2800 S 290 1120 – 0. 2008 Sales Profits before tax Taxes Profit after tax (8% on sales) Dividends Retained earnings (ii) Projected Balance Sheet as at 31.3) L ∆S – m S1 (1-d) = Rs.12 2001 Liabilities Share capital Retained earnings Term loans (360+146) Short-term bank borrowings (300 + 146) Accounts payable Provisions Assets 500 340 506 446 294 112 2198 Fixed assets Inventories Receivables Cash 1050 560 462 126 3.

429 1. b.410.410 Projected Income Statement for Year Ending 31st March .490 Cash 180 Accounts Payable 1. assuming that the external funds requirement would be raised from term loans and short-term bank borrowings in the ratio 1:2 (i) projected balance sheet and (ii) projected profit and loss account.07 x 40.5) 31.(i) - 2020 9. Likewise the profit margin ratio. 2007 were 31.110 15. and the dividend payout ratio would remain unchanged.920 Receivables 2. The ratio of assets to sales and spontaneous current liabilities to sales would remain unchanged.200 Fixed assets 8.423 – 0.833 4.580 Short-term Bank Borrowings 2. Prepare the following statements.9.---S S ∆S – m S1 (1-d) 15. 2007 is shown below: Share capital 4. the tax rate.423) in the year 20X8.. The balance sheet of MGM Limited as at March 31. Required: a. EFR = A L ---.240 Provisions 780 15. 2008 Sales Profits before tax Taxes Profit after tax (7% on sales) Dividends Retained earnings 40.480 Term Loans 3.858 1.429 .110 The sales of the firm for the year ending on March 31. Its profit margin on sales was 7 percent and its dividend payout ratio was 50 percent. The tax rate was 34 percent. MGM Limited expects its sales to increase by 30 percent(i. Solution: a.480 Inventories 3.870 Retained Earnings 2.410 = 2498 b.833 (1-0.472 2.330 1.e by 9. Estimate the external funds requirement for the year 2008.110 = 31.

354 234 19.721 Retained Earnings 6.909 Term loans (3920+2498x1/3) 4. The tax rate was 33 percent. the tax rate.545 25.378 Cash 254 Accounts Payable 1.014 19.200 Retained earnings 3. Its profit margin on sales was 10 percent and its dividend payout ratio was 45 percent.531 4.258 Fixed assets 15. 20x7 is shown below: Share capital 6. . The ratio of assets to sales and spontaneous current liabilities to sales would remain unchanged.320 Receivables 3.524 3. assuming that the external funds requirement would be raised entirely from short-term bank borrowings :(i) projected balance sheet and (ii) projected profit and loss account. Ganesh Associates expects its sales to increase by 50 percent in the year 20X8.984 Term Loans 5.545 The sales of the firm for the year ending on March 31.780 Inventories 5.586 Short-term Bank Borrowings 4. b.612 Provisions 1.753 Short-term bank borrowings 4.155 (2490 + 2498x2/3) Accounts payable 1. Likewise the profit margin ratio. The balance sheet of Ganesh Associates as at March 31.436.(ii) Projected Balance Sheet as at 31. Estimate the external funds requirement for the year 20x8. Prepare the following statements. Required: a.643 Assets Fixed assets Inventories Receivables Cash 11.3 2008 Liabilities Share capital 4.873 Provisions 936 25. 20x7 were 58.643 10. and the dividend payout ratio would remain unchanged.

5 Previous year’s sales = 24. The following information is given for ABC Company: Assets to sales ratio = 0.547 Projected Income Statement for Year Ending 31st March .317 8.601 5.944 4.000 What is the maximum sales growth rate that can be financed without raising external funds? .976 5.3 2008 Liabilities Share capital Retained earnings Term loans Short-term bank borrowings (4378 + 6547) Accounts payable Provisions Assets Fixed assets Inventories Receivables Cash 6..654 13.765 3.809 29.258 11.∆S – m S1 (1-d) S S EFR = 25.Solution: A L ----.45) 58. 2008 Sales Profits before tax Taxes Profit after tax (10% on sales) Dividends Retained earnings 87.-----.80 Spontaneous liabilities to sales ratio = 0.317 23.654 (1-0.317 11.10 x 87.40 Profit margin = 8 per cent Dividend payout ratio = 0.925 2.320 10.581 8.6.821 Projected Balance Sheet as at 31.436 = Rs.379 381 38.545 = 58.218– 0.082 4.436 - 2.809 1.404 38.

4g (0. d= 0. The following information is given for Rahul Associates.9-0.033/0. m= 0.04 or g = 0.5) (0. m= 0.11 .4 .8-0. (0.8 .033 or g = 0. Assets to sales ratio = 0.04(1+g) = 0.4 -0.90 Spontaneous liabilities to sales ratio = 0.4 -0. L/S= 0.3) (0.50 Spontaneous liabilities to sales ratio = 0.: Assets to sales ratio = 0.7 and EFR = 0 we have.5 and EFR = 0 we have.5 . 8.4g (0.033)g = 0.Solution: EFR = A - L - m (1+g) (1-d) ∆S S S g Given A/S= 0. d= 0.20 Profit margin = 6 per cent Dividend payout ratio = 0.000 =0 .e.08 .04)g = 0.1111 i.04/0.11% 12. (0.1 Previous year’s sales = 12.360 What is the maximum sales growth rate that can be financed without raising external funds? =0 Solution: EFR A L m (1+g) (1-d) = ∆S S S g Given A/S= 0.5) g 0.0899 i. 11.e.033(1+g) = 0.36 = 0. The following information is given for Ahuja Enterprises.11)(1+g)(0.367 = 0.9 .7 Previous year’s sales = 45.50 Profit margin = 11 per cent Dividend payout ratio = 0.99% 13.08)(1+g)(0.4) g 0. L/S= 0.

21. The balance sheet of Arvind Company at the end of year 20 x 7.3.2 .2) g 0.95% 14. which is just over. L/S= 0.1 and EFR = 0 we have.054(1+g) = 0.9) (0. (b) How should the company raise its external funds requirement. The expected sales for the year 20x8 are 1702.054/0.06)(1+g)(0. Required: (a) Determine the external funds requirement for Arvind for the year 20x8.06 . and additional equity issue. d= 0.3g (0.246 = 0. (ii) The ratio of fixed assets to long-term loans should be greater than 1.5-0. Assume that the company wants to tap external funds in the following order: short-term bank borrowing.2195 i. (0.3.e.054)g = 0.What is the maximum sales growth rate that can be financed without raising external funds? Solution: EFR = A - L - m (1+g) (1-d) ∆S S S g Given A/S= 0. if the following restrictions apply? (i) Current ratio should not be less than 1.3 -0. =0 Solution: A (a) EFR = S - L ∆S – mS1 (1-d) S . The profit margin is 8 percent and the dividend payout ratio is 30 percent. long-term loans. m= 0.5 . is given below: Share capital 200 Fixed assets 280 Retained earnings 120 Inventories 230 Long-term borrowings 210 Receivables 210 Short-term borrowings 150 Cash 60 Trade creditors 70 Provisions 30 780 780 The sales for the year just ended were 1480.054 or g = 0.

3) 1480 i. Ratio of fixed assets to long term loans ≥ 1.e CL CA ≥ 1.3 i. we have : .3 ii. we get 1.15 = 322 322 ∴LTL ≤ or LTL = 247.e STL = 327.15 = 115 Substituting these values.5 425.3 STL +SCL As at the end of 20X8.7 1. CA = 500 x 1. FA = 280 x 1.3 FA ≥ 1.3 or or STL ≤ 1.15 = 575 SCL = 100 x 1.3 If ∆ STL and ∆ LTL denote the maximum increase in ST borrowings & LT borrowings.3 LTL At the end of 20X8.3 CA i.5 greater than or equal to 1. Let CA = denote Current assets CL = Current liabilities SCL = Spontaneous current liabilities STL = Short-term bank borrowings FA = Fixed assets and LTL = Long-term loans Current ratio ≥ 1.780 = 1480 = 61 (b) - 100 x 222 – (0.3 STL ≤ 575− (115 x 1.3 (STL + 115) ≤ 575 or 1.08) (1702) (0.3) ≤ 425.

3 ∆ LTL = LTL (20X8). b How should the company raise its external funds requirement.∆ STL = STL (20X8) – STL (20X7) = 327.160 Inventories 25. long-term loans.420 Long-term borrowings 28. The expected sales for the year 20x8 are 227.400 The sales for the year just ended were 162.4) 162.400 = 162. Solution: A (a) EFR = S S L ∆S – mS1 (1-d) 82. (ii) The ratio of fixed assets to long-term loans should be greater than 1.7 – 210 = 37.400 82. if the following restrictions apply? (i) Current ratio should remain unchanged.LTL (20X7) = 247. and additional equity issue.360 Receivables 18.520 Cash 560 Trade creditors 380 Provisions 980 82.120– (0.800 .360 x 65.3 – 150 = 177. Required: a Determine the external funds requirement for Kamath Enterprises for the year 20x8.920) (0. The balance sheet of Kamath Enterprises at the end of year 20 x 7.7 Hence.5.10) (227. which is just over. Assume that the company wants to tap external funds in the following order: short-term bank borrowing. is given below: Share capital 35.000 Fixed assets 37. The profit margin is 10 percent and the dividend payout ratio is 40 percent.920.540 Short-term borrowings 16. the suggested mix for raising external funds will be : Short-term borrowings 61 Long-term loans ----Additional equity issue -61 15.299 - 1.880 Retained earnings 1.800.800 = 23.

4 = 23.355 – 28.880 x 1.240 Projected sales increase for next year = 25 percent Profit after tax this year = 4.4 = 53.000 Present level of spontaneous current liabilities = 12.032 53.128 – 16.5 LTL At the end of 20X8. we have : ∆ STL = STL (20x8) – STL (20X7) = 23.LTL (20X7) = 35.355 1.696 23. the suggested mix for raising external funds will be: Short-term borrowings 6.360 = 6.520 x 1.520 = 6. The following information is available about Headstrong Limited: Sales of this year = 48.032 ∴LTL ≤ or LTL = 35. 608 Long-term loans 6. 608 ∆ LTL = LTL (20X8).5 FA ≥ 1.128 (ii) Let FA = Fixed assets STL = Short-term loans and LTL = Long-term loans Ratio of fixed assets to long term loans ≥ 1.380 What is the level of total assets for Headstrong now? . FA = 37.b (i) The current ratio will remain unchanged when the assets and liabilities rise in the same proportion.995 Additional equity issue 9.824 Dividend payout ratio = 40 percent Projected surplus funds available next year = 2.299 16.5 If ∆ STL and ∆ LTL denote the maximum increase in ST borrowings & LT borrowings .995 Hence. The Short term borrowing as on March 31. 2008 should therefore be = 16.

060 = 2.014x (1-0. mS1(1-d) – L L ∆ S – m S1 (1-d) ∆S represents surplus funds S S Given m= 0.300x (1-0.780 Projected sales increase for next year = 30 percent Profit after tax this year = 15.300 What is the level of total assets for Meridian now? Solution: A EFR = S S A Therefore.000 we have A 14.234 = 7.000 100.4 .720 ∴ The total assets of Meridian must be 23.240 and surplus funds = 2.780 or A = 2.780 (A – 14.240 A – 12.780 100.380 = 3618-2000 = 1618 4 or A = 4 x 1618+ 12.380 = 18.15) x 131. S1 = 60.852 17.117 Dividend payout ratio = 50 percent Projected surplus funds available next year = 7.240 48.300 = 23.234 + 14.000 Present level of spontaneous current liabilities = 14.5 .826 100.780 and surplus funds = 7. mS1(1-d) – L L ∆ S – m S1 (1-d) ∆S represents surplus funds S S Given m= 0. S= 100. L= 14.780/30.826 x 100.000 48. The following information is available about Meridian Corporation: Sales of this year = 100. S1 = 131.014.234 = 9826.10.300 (0. L= 12.720 .380 (0.7000 = 2.10) x 60.000 we have A 12. d= 0.5) x 30.380 S= 48.852 ∴ The total assets of Headstrong must be 18.4) x 12.300.300)x 30.300 .Solution: A EFR = S S A Therefore.15 . d= 0.

048 A/E . A/S = 1.4 .144/0.08 = 1.4) x A/E 0.8 (a) What is the rate of growth that can be sustained with internal equity? (b) If Maharaja Limited wants to achieve a 8 percent growth rate with internal equity.144 = 0.24 + 0.44 % The dividend payout ratio must be raised by 4.. d = 0.0 (b) 0.00384 A/E = 0.4 percent.18.07 = 1.08 (1-0.144 – 0.0192) = 0.8 -. other ratios remaining unchanged? (d) If Maharaja Limited wants to achieve a 7 percent growth rate with internal equity.08 (1-d) x 3.0192 + 0. 0.24 – 0.8 – m (1-0.8 m (1-d)A/E (a) g= A/S –m(1-d)A/E .0192 – 0.0 Assets-to-sales ratio = 1.05184 =2.1152 d = 0.22 m (1-0.8 -.0192 d = 0. what should be the improvement in the profit margin.08 = 1. what change must occur in the assets-to-sales ratio.0 0. other ratios remaining unchanged? (e) If Maharaja Limited wants to achieve a 7 percent growth rate with internal equity.4) A/E 0.4) x 3 = 1.78 Assets to equity ratio should be reduced by 0. what change must be made in the assets-to-equity ratio. what change must be made in the dividend payout ratio.4) 3.d ) 3.4) 3 (d) .08 .0 = 8.4444 or 44.8 . other ratios remaining unchanged? (c) If Maharaja Limited wants to achieve a 8 percent growth rate with internal equity.7 per cent (c) .4) 3.0 . A/E = 0.144 – 0.08 (1.08 (1-0. Maharaja Limited has the following financial ratios: Net profit margin ratio = 8 percent Target dividend payout ratio = 40 percent Assets-to-equity ratio = 3.24 + 0.08 (1-0.24 d d( 0. other ratios remaining unchanged? Solution: m= .0 .08 (1-0. A/E = 3.

0126) = 0. m =0. what should be the improvement in the profit margin.4) 3 (e) . what change must occur in the assets-to-sales ratio.154/0.01 = 0.2 The asset to sales ratio must increase from 1.0 -.8 0.2 19.8 Assets-to-sales ratio = 1.35) 1.126/1.8 to 2.8m .10)/(1.0 (a) What is the rate of growth that can be sustained with internal equity? (b) If Majestic Corporation wants to achieve a 10 percent growth rate with internal equity.1%.26 d d = ( 1.08 (1-0.126m = 1.26 + 0.10 -0.0126 d = 1.07 (1-0.54 per cent . Majestic Corporation has the following financial ratios: Net profit margin ratio = 7 percent Target dividend payout ratio = 35 percent Assets-to-equity ratio = 1. .07 = 2.08 (1-0..926 = 6.0 m (1-d)A/E (a) g= A/S –m(1-d)A/E = 1.54 % The net profit margin must be reduced from 8 per cent to 6.0126 + 0. what change must be made in the assets-to-equity ratio. A/S = 0.8 = 8.07 (1-0.0 -. other ratios remaining unchanged? (e) If Majestic Corporation wants to achieve a 6 percent growth rate with internal equity.26 + 0.8 (b) g= = 0. what change must be made in the dividend payout ratio.0126 – 0.1% The dividend payout ratio must be raised from 35 % to 92.10 1.9 per cent . other ratios remaining unchanged? (d) If Majestic Corporation wants to achieve a 12 percent growth rate with internal equity.126 -0.35 .07 (1-d) 1.4) 3 0.07 A/S – 0.26 – 1.07 (1-d) 1.0.35) 1.8 .0.144 . d = 0.8 . A/S = 1. other ratios remaining unchanged? Solution: m= .07 = A/S . A/E = 1.07 . other ratios remaining unchanged? (c) If Majestic Corporation wants to achieve a 11 percent growth rate with internal equity.921 or 92.

000 made today if the interest rate is (a) 4 percent.11 – 0.12 – 0.07 (1-0. .29.07 (1-0.35) 1.000 x1.0 to 1.8 0.06 A/S – 0. and (d) 9 percent. A/S = 1.340 . m = 0.38 The assets to sales ratio should be raised from 1.06 = A/S -.8 to 2.791 =Rs.0.1404 m = 1.005005) = 2.38 CHAPTER 6 1.11/(0. 10 years) 20. 10 years) 20. 10 years) 20. (b) 6 percent.35.20.000 x 2.35) 1. (d) m (1-0.43.000 x FVIF (8 %.159 =Rs.17 m .000 x FVIF (4%.180 20.(c) .0455+0.2.2 Assets to equity ratio should be raised from 1.000 x 2.8 0.35) A/E 0.07 (1-0.820 20.0819.07 (1-0.0 -m (1-0. Solution: Value 10 years hence of a deposit of Rs.12 = 1. 10 years) 20.000 at various interest rates is as follows: r r r r = = = = 4% 6% 8% 9% FV5 FV5 FV5 FV5 = = = = = = = = 20.8 0.600 20.0049 = 0. (c) 8 percent. 47.11 1.000 x FVIF (6 %.8 0.20. (e) .367 =Rs.0455 A/E A/E = 0.0 -.000 x FVIF (9 %.480 = Rs.005005 A/E = 0.09 or 9 % The net profit margin should be changed from 7 percent to 9 percent.35) 1.0.0. Calculate the value 10 years hence of a deposit of Rs.35) A/E = 0.35) 1.000 x 1.

000 in approximately 4 x 12 years = 48 years 4.800 x 1. 9.800 made today if the interest rate is (a) 12 percent. Solution: Rs.8. 3 years) 5.405 =Rs.822 5.800 x 1.192.596 5. 5.561 =Rs. 3 years) 5. 2.000 today at 8 percent rate of interest in how many years (roughly) will this amount grow to Rs.482 =Rs. Solution: Rs.149 5.3000 will grow to Rs.000 will grow to Rs.92.800 x 1.800 x 1. and (d) 16 percent. If you deposit Rs.000 in approximately 6 x 9 years = 54 years .800 x FVIF (16%.8.800 x FVIF (15%.000 today at 6 percent rate of interest in how many years (roughly) will this amount grow to Rs.000 = 64 = 26 According to the Rule of 72 at 8 percent interest rate doubling takes place approximately in 72 / 8 = 9 years So Rs. Calculate the value 3 years hence of a deposit of Rs.32. If you deposit Rs. Solution: Value 3 years hence of a deposit of Rs.5.8.800 x FVIF (12%.2.000 = 16 = 24 According to the Rule of 72 at 6 percent interest rate doubling takes place approximately in 72 / 6 = 12 years So Rs.054 r = r = r = 16 % FV5 3.000 / Rs.000 / Rs.000 ? Work this problem using the rule of 72–do not use tables.000 ? Work this problem using the rule of 72–do not use tables.521 =Rs. (c) 15 percent.2.2.32. 3. 3 years) 5.32.800 at various interest rates is as follows: r = 12 % FV5 14 % FV5 15 % FV5 = = = = = = = = 5.3.1.192. 3 years) 5.800 x FVIF (14%. (b)14 percent.

figure out the approximate interest rate offered.35 + 69 / Interest rate We therefore have 0. We therefore have 0.5.35 + 69 / Interest rate = 6 Interest rate = 69/(6-0. Solution: In 18 years Rs.000 or 4 times. What will these savings cumulate to at the end of 10 years. figure out the approximate interest rate offered.38 % 6.5000 a year for 3 years and Rs.6000 a year for 7 years thereafter is equivalent to saving Rs.10. A finance company offers to give Rs.000 deposited today.5. You can save Rs.35 + 69 / Interest rate = 7 Interest rate = 69/(7-0.80. According to the Rule of 69. if the rate of interest is 8 percent? Solution: Saving Rs.000 a year for 3 years. Using the rule of 69. This is 22 times the initial deposit.000 after 14 years in return for Rs.20. the doubling period is 0.35 + 69 / Interest rate.80.5.000 or 8 times.000 a year for 7 years thereafter. This is 23 times the initial deposit. Hence doubling takes place in 18 / 3 = 6 years.000 to you after 18 years in return for Rs. the doubling period is 0.000 deposited today. 7 years) = 5000 x 14.5000 a year for 10 years and Rs.2000 a year for the years 4 through 10.10.923 = Rs. Hence the savings will cumulate to: 5000 x FVIFA (8%.000 grows to Rs.20.487 + 2000 x 8.35) = 10.21 % 7. 10 years) + 2000 x FVIFA (8%. Using the rule of 69. Someone offers to give Rs.35) = 12. Hence doubling takes place in 14 / 2 = 7 years.5.90281 . According to the Rule of 69. and Rs.000 grows to Rs.7. Solution: In 14 years Rs.

30. A = 2. You have decided to accumulate this amount by investing a fixed amount at the end of each year in a safe scheme offering a rate of interest at 10 percent.00.000 2.000 will be needed for this purpose at that time. 1.24.000 80. what will be the value of his savings at the end of 20 years? Solution: Saving Rs. Krishna saves Rs. What amount should you invest every year to achieve the target amount? Solution: Let A be the annual savings.000 a year for the years 6 through 20. A x FVIFA (9 %.6.000 x 51.000 x FVIFA (9%.105 10. Solution: Let A be the annual savings.028 = .24. 8 years) A x 11.000 Rs.2.160 + 6. 15 years) = 24. 7.25. 000 x 29. if he wishes to purchase a flat expected to cost Rs. If the rate of interest is 9 percent compounded annually.028 = = 80.426 So. if the investment option available to him offers a rate of interest at 9 percent? Assume that the investment is to be made in equal amounts at the end of each year. 327.006 9.000.30. A x FVIFA (10%.000 / 11.000 a year for 5 years.000.404.00. Hence the savings will cumulate to: 24.000.000 a year for 20 years and Rs.00.000 / 6. You plan to go abroad for higher studies after working for the next five years and understand that an amount of Rs. 5years) A x 6.000.24.105 So.361 =Rs.000 a year for 15 years thereafter is equivalent to saving Rs. = = = 2.000 Rs.600 How much should Vijay save each year.000 x FVIFA (9 %.000 a year for 15 years thereafter. 20 years) + 6.80 lacs after 8 years. and Rs. A = 80.8.000 a year for 5 years and Rs.

000.000 100.000 = 8. 6 years) = 2.000 at the end of 5 years to investors who deposit annually Rs.1.5 From the tables we find that FVIF (16%.000 x FVIF (r.000.048 8. 5 years) From the tables we find that FVIFA (24%.75% Solution: 2. Someone promises to give you Rs.333 Using linear interpolation in the interval.000 / 2.5 % .436) 13.000.000.000 = 2.700 – 8. Rahul is given a choice between two alternatives: (a) an annual pension of Rs120.12. and (b) a lump sum amount of Rs. we get: (2. 6 years) = 5. which option appears more attractive = 16.5 – 2. If Rahul expects to live for 20 years and the interest rate is expected to be 10 percent throughout .000 after 6 years in exchange for Rs.048) 12.048) r = 24% + (8.000 x FVIFA (r.5. 5 years) = = 8. 6 years) = FVIF (17%.000.000.700 = 100. What interest rate is implicit in this offer? x 4% = 25.000.000 FVIF (r. 5 years) = FVIFA (r.333– 8.565 Using linear interpolation in the interval.000. 5 years) FVIFA (28%. we get: (8.436 2.000 as long as he lives.565 – 2. A finance company advertises that it will pay a lump sum of Rs. What interest rate is implicit in this offer? Solution: 12.000 / 12.100.2. At the time of his retirement.000 today. 6 years) = 5.11.436) x 1 % r = 16% + (2.000.

772 = Rs.000 Rahul will be better off with the annual pension amount of Rs.64. 60.000 x PVIF (15%.000 x PVIF (15%.000. 3 years) = 30.917 + 50.000 x 6. which option would you choose? Solution: The present value of an annual payment of Rs.000 for the next 10 years.021.000 during each of the years 4 through 10.000 at the end of year one.000 at the end of years two and three . and Rs. A leading bank has chosen you as the winner of its quiz competition and asked you to choose from one of the following alternatives for the prize: (a) Rs.000 x PVIF (9%. and Rs. if the discount rate is 9 percent ? Solution: The present value of the income stream is: 30.000 in cash immediately or (b) an annual payment of Rs.000 x PVIFA (10%.418 = Rs. Rs.000 for 20 years when r = 10% is: 120.680 The alternative is to receive a lumpsum of Rs 1.120.000 x PVIFA (9 %. 1 year) + 30. Rs. 16. 7 years) x PVIF(9%. 10 years) = 10.000 during each of the years 4 through 8 if the discount rate is 15 percent ? Solution: The present value of the income stream is: 25.000 x PVIF (9%. 14.120.000 x 5.180 The annual payment option would be the better alternative 15.000 at the end of year three .50.25.1.454.40.Solution: The present value of an annual pension of Rs.514 = Rs. What is the present value of an income stream which provides Rs. 20 years) = 120.000 x 8.658.100.000 x PVIFA ( 9 %.10. 2 years) .30. 1 year) + 50.30. 10.000 x 0.000 for 10 years when r = 9% is: 10.0. If the interest rate you can look forward to for a safe investment is 9 percent.033 x 0.772 + 100. What is the present value of an income stream which provides Rs.000 at the end of year one. 3 years) + 100.000.000 x 0.

712 = Rs.000 / 0. Mr.000 x PVIF (15%.000 PVIF (12%.567 = Rs. The amount that must be deposited to get this sum is: Rs.000 x 0. What is the present value of an income stream which provides Rs. 1.30. 10 years) + (30.352 x 0.000 annually for 3 years.000/ 0.240.000 forever .000 forever beginning from the end of 6 years from now ? The deposit earns 12 percent per year.756 + 30.134.270 = Rs.000 x 0.000 x PVIFA (12%.000 a year for the first 10 years and Rs.2.000 x 2.000 x 3.395.5.100. beginning from the end of 6 years from now.12) x PVIF (12%.658 = Rs. 17.402 + (5000/0. 10 years) = 20. If you deposit Rs.2.000.216 + (30.000 a year forever thereafter.000 x 0.152.240.000 x PVIFA (15 %.000 x PVIFA (14%. Solution: To earn an annual income of Rs.1.000 a year for the first three years and Rs.000.12) x 0.000/ 0. if the discount rate is 14 percent ? Solution: The present value of the income stream is: 20.658 + 40.14) x PVIF (14%.000 is required at the end of 5 years.14) x 0.000 with him he promises to pay Rs. 3 years) + 40.240.177 19.000. 3 years) = 25. What interest rate would you earn on this deposit? .000/0.20.12 = Rs.000 20.2.50. 5 years) = Rs. 3 years) + (5. 3 years) = 1. Ganapathi will retire from service in five years . What is the present value of an income stream which provides Rs.000 x 0.32. if the discount rate is 12 percent? Solution: The present value of the income stream is: 1.162.How much should he deposit now to earn an annual income of Rs. if the deposit earns 12% per year a sum of Rs.069 18. 5 years) x PVIF (15%.+ 30.870 + 30.000 x 5.000 a year forever thereafter. Suppose someone offers you the following financial contract.

10 years) Using linear interpolation we get: 6.57 % 22 What is the present value of the following cash flow streams? End of year Stream X Stream Y Stream Z 1 500 750 600 2 550 700 600 3 600 650 600 4 650 600 600 5 700 550 600 6 750 500 600 --------------------------------------------------------------------------------------------The discount rate is 18 percent. 3 years) PVIFA (r.00 From the tables we find that: PVIFA (10 %. 10 years) PVIFA (11 %. = 6.981 x 4% Solution: Rs.889 = 10. 3 years) PVIFA (24 %.100.39 % 21.889 x 1% .00 From the tables we find that: PVIFA (20 %.000 annually for 10 years.00 r = 10 % + ---------------6.145 – 5. If you invest Rs.000 =.000 with a company they offer to pay you Rs.145 = 5. 3 years) Using linear interpolation we get: 2.Rs.600.000 x PVIFA (r.145 – 6.600.00 r = 20 % + ---------------2.981 = 23.50.3 years) = 2.106 – 1.106 = 1.000 x PVIFA (r.Solution: Rs.Rs.100. What interest rate would you earn on this investment? = 2.106 – 2.10 years) = 6. 10 years) PVIFA (r.000 =.100.

200.02)60 Rs.437 + 750 x 0. 2yrs) + 650 PV( 18%.281 Rs. 4yrs) + 700 PV( 18%.Solution: PV( Stream X) = 500 PV( 18%.000 for three years? Solution: Maturity value = USD 15 .50 25. 6yrs) == 750 x 0.000 (1.8 23.000 x 1. 5yrs) + 500 PV( 18%. 1yr) +700 PV( 18%. 3yrs) + 650 PV( 18%.370 = 2102. 6yrs) = 600 x 3.65 PV (Stream X) = 600 PVIFA (18%.200 24.200.000 (1. What is the difference between the effective rate of interest and stated rate of interest in the following cases: Case A: Stated rate of interest is 8 percent and the frequency of compounding is six times a year. 6yrs) = 500 x 0.05 / 2)]3x2 = 15. A bank pays interest at 5 percent on US dollar deposits.718 + 600 x 0.437 + 500 x 0.200. compounded once in every six months.847 +550 x 0.516 + 700 x 0. Case C: Stated rate of interest is 12 percent and the frequency of compounding is twelve times a year. 5yrs) + 750 PV( 18%.656.000 [1 + (0.516 + 550 x 0. 3yrs) + 600 PV( 18%.395. 2yrs) + 600 PV( 18%. What will be the maturity value of a deposit of US dollars 15. how much will this deposit grow to in 10 years? Solution: FV10 = = = = Rs.000 x 3.000 with an investment company which pays 12 percent interest with compounding done once in every two months.12 / 6)]10x6 Rs.000 [1 + (0.498 = 2098. .6 PV( Stream X) = 750 PV( 18%.200.718 + 650 x 0.609 + 600 x 0.1597 = 17.025)6 = 15.609 + 650 x 0.370 = 2268.847 +700 x 0. 4yrs) + 550 PV( 18%. 1yr) +550 PV( 18%. Case B: Stated rate of interest is 10 percent and the frequency of compounding is four times a year. Suppose you deposit Rs.

68 Frequency of compounding 6 times Effective rate (%) (1 + 0.600.000 after 8 years in lieu of Rs.500.000 [1 + (0. What will the deposit grow to after 5 years? If the inflation rate is 3 percent per year.500.000 FVIF (r.09 / 4)]5x4 = Rs.000 Rs. 27.08/6)6.000 Rs.000 x FVIF (r.1 = 8.600.38 0.0225)20 = Rs.255 .27 0.200.000 after 8 years from now because I find a return of 15% quite attractive.653 = Rs. I would choose Rs.200.000 From the tables we find that FVIF (15%. 8years) = 3. Which would you choose? What does your preference indicate? Solution: The interest rate implicit in the offer of Rs.000 now and Rs. 0.600.500.600. The interest rate is 9 percent and compounding is done quarterly. what will be the value of the deposit after 5 years in terms of the current rupee? Solution: FV5 = Rs.000 now is: Rs.000 after 8 years.200.8 years) = = 3.200.059 This means that the implied interest rate is nearly 15%.38 C 12 12 times (1 + 0. Ravikiran deposits Rs.000 x 2.780.Solution: A Stated rate (%) 8 B 10 4 times (1+0.27 Difference between the effective rate and stated rate (%) 26.000 in a bank now.68 You have a choice between Rs.12/12)12-1 = 12.8 years) = Rs.000 (1.10/4)4 –1 = 10.500.600.

the value of Rs.292 29.379. 5 years) = Rs.08 x 2.255 x PVIF (3%.100. evaluated as at the beginning of 2014 (or end of 2013) is: Rs. 5 years) = Rs. 2 years) = Rs.250 A x 1.780.780. Solution: The discounted value of Rs.000 x 2.000 x PVIFA (10%.We then have Ax (1+0. 3 years) = Rs.792 .250. evaluated as at the beginning of 2009 (or end of 2008) is: Rs.250 To have Rs.137 A = Rs. if the interest rate is 10 percent.100 The discounted value of Rs.000 at the beginning of each year from 2015 to 2019.000 x 3.250.080 = 644.000 at the beginning of each year from 2010 to 2012.255 x 0.791= Rs.360 28.100.313.250. How much should you deposit( in equal amounts) at the beginning of each year in 2007 and 2008 ? The interest rate is 8 percent.000 x PVIFA (8 %. 5 years) = Rs.105 = Rs.379. 863 = Rs.137 If A is the amount deposited at the end of each year from 2007 to 2011 then A x FVIFA (10%.255 5 years from now.780.100 x 0.250 .08) x FVIFA ( 8%.250 at the end of 2008. You require Rs. in terms of the current rupees is: Rs.100 x PVIF (10 %.577= Rs.105 = Rs.250 or A = 286. how much should he deposit ( in equal amounts) at the end of each year from 2007 to 2011.313.313.379.379.100.826= Rs. Towards this. let A be the amount that needs to be deposited at the beginning of 2007 and 2008.If the inflation rate is 3 % per year.137/ 6.000 receivable at the beginning of each year from 2015 to 2019. 644.137 A x 6.100 evaluated at the end of 2011 is Rs.100.000 receivable at the beginning of each year from 2010 to 2012. 2years) = 644. Solution: The discounted value of Rs.644.51.673.313. A person requires Rs.

7 years) = Rs.4.576.452 = Rs.000 x 7. How much can Mr. 896.01)240 .080is: Rs.418 = Rs. 20 years) = Rs.896.000 x PVIFA (1%.278 . the discounted value of an annuity of Rs.865 32. 576.000 per month for 20 years.290 x 0. What is the present value of Rs.10.01)240 .4.120.000 receivable at the end of each month for 240 months (20 years) is: Rs.080 The present value of Rs. Solution: The discounted value of the annuity of Rs. 576.708 = Rs.469 = Rs.080x PVIF (9%.120. 576.4.89. What is the present value of Rs.290 The present value of Rs.363.30. 896.119 31. Solution: 40 per cent of the pension amount is 0.405.000 x (1.10.120.290 x PVIF (12%. 4 years) = Rs.760 receivable annually for 10 years if the first receipt occurs after 5 years and the discount rate is 9 percent.080x 0. Solution: The discounted value of the annuity of Rs. evaluated as at the end of 4th year is: Rs.000 = Rs.01 (1. After eight years Mr.760 receivable for 10 years.120.40 x Rs.4.000 receivable annually for 20 years if the first receipt occurs after 8 years and the discount rate is 12 percent. 89.89. Tiwari borrow now at 12 percent interest so that the borrowed amount can be paid with 40 percent of the pension amount? The interest will be accumulated till the first pension amount becomes receivable. 896. 240) Rs.Tiwari will receive a pension of Rs.000 x PVIFA (12%. 10 years) = Rs. 89.760 x PVIFA (9%.000 Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is 1%.1 ---------------.760 x 6.407.290 is: Rs. evaluated as at the end of 7th year is: Rs.= Rs.000 receivable for 20 years.

25.525.750 Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is 1%. the discounted value of an annuity of Rs.3. An instalment of Rs.569 -----------.1 ---------------.722 2. Khanna borrows Rs.569 Rs.3.P today on which the monthly interest rate is 1% P x (1.750 x If Mr.If Mr.000 = Rs.3.000= 21 .525.= Rs. 363.= Rs.01 (1.01)360 . 360) (1.278 -----------.25 x Rs.25.000 / Rs.000 per month for 30 years.364.000.000 is payable to the bank for each of 30 months towards the repayment of loan with interest. What interest rate does the bank charge? Solution: Rs.15.25.486 1. 30 months) = Rs.3.750 receivable at the end of each month for 360 months (30 years) is: Rs. 363.01)12 = P x 1. 363.323.127 = Rs.278 Rs. 30 months) = Rs. 364.139.127 P = 34. Khanna will receive a pension of Rs. Solution: 25 per cent of the pension amount is 0.569 Rs. Khanna borrow now at 12 percent interest so that the borrowed amount can be paid with 25 percent of the pension amount? The interest will be accumulated till the first pension amount becomes receivable.000 x PVIFA(r. 364.P today on which the monthly interest rate is 1% P x (1. After one year Mr.60 P = 33. You buy a car with a bank loan of Rs.01)360 Rs.000 PVIFA (r. How much can Mr.525.15. Tiwari borrows Rs.01)96 = P x 2.278 Rs.569 .60 = Rs. 364.= Rs.750 x PVIFA (1%.

the bank charges an interest rate of 2.12.174. 18 months) = Rs.88 % . 18 months) = Rs.12.174.50% x 1% Thus.0250)12 – 1 ] x 100 = 34.397 % per month.50 % per month.000 x PVIFA(r.397 Using a linear interpolation 22.992 – 14.5 From the tables we find that: PVIFA(2%.397% x 1% Thus. 18) = 14.000= 14.397 – 21. The corresponding effective rate of interest per annum is [ (1.000 What is the effective annual interest rate charged by the bank ? Solution: Rs.From the tables we find that: PVIFA(3%. 30) = PVIFA (2%.174.000 repayable with interest in 18 monthly instalments of Rs.992 – 13.754 Using a linear interpolation 14. 18) = PVIFA (3%.600 = 2.500 r = 2% + ---------------------14.49 % 35.000 / Rs. the bank charges an interest rate of 2.02397)12 – 1 ] x 100 = 32.397 – 19.12.992 13.754 = 2.000 PVIFA (r. You take a bank loan of Rs. 30) = 19.600 22. The corresponding effective rate of interest per annum is [ (1.000 r = 2% + ---------------------22.

49.91.20 million x PVIFA (10%. Solution: The discounted value of the debentures to be redeemed between 7 to 10 years evaluated at the end of the 6th year is: Rs.30 million x 3. and 8 years from now.357 38.105 = Rs.11 million If A is the annual deposit to be made in the sinking fund for the years 1 to 6. Metro Corporation has to retire Rs.000 can be withdrawn annually.11.000 at the end of each year. then A x FVIFA (10%. If he plans to withdraw Rs.487 If A is the annual deposit to be made in the sinking fund for the years 1 to 5. then A x FVIFA (12%. 6 years) = Rs.74 million A x 6. 7. He deposits it in a bank which pays 9 percent interest. Ankit Limited has to retire Rs. 8. 91.115 = Rs.74million = Rs.11 million A = Rs.147. 3 years) = Rs. in order to meet the debenture retirement need? The net interest rate earned is 12 percent.36. How much should the firm deposit in a sinking fund account annually for 5 years.49.800.20 million x 2. 9 and 10 years from now. 5 years) = Rs.8. .227. in order to meet the debenture retirement need? The net interest rate earned is 10 percent.Mehta receives a provident fund amount or Rs.91.20 million of debentures each at the end of 6. How much should the firm deposit in a sinking fund account annually for 5 years.30 million x PVIFA (12%. how long can he do so ? Solution: Let `n’ be the number of years for which a sum of Rs.000.11 million A x 8.100.74 million A = Rs.49.100.30 million of debentures each at the end of 7. 4 years) = Rs.420 37. Solution: The discounted value of the debentures to be redeemed between 6 to 8 years evaluated at the end of the 5th year is: Rs.037 = Rs. Mr.

What fraction of the instalment at the end of second year will represent principal repayment ? 3.Rs.100.786 39. 15 years) = 8.x 1 = 5.111 Solution: 1. Naresh wants to invest an amount of Rs. 14 years) = 7. n) = Rs. in a finance company at an interest rate of 12 percent.100.000 From the tables we find that PVIFA (9%. with instructions to the company that the amount with interest be repaid to his son in equal instalments of Rs.329 .786 n = 14 + ----------------8.000 – 3.78 years Mr.000.100.800.000 Annual instalment = 3.400.000 x PVIFA (12%.605 4.000 / Rs.100. 6 years) = Using a linear interpolation we get 4.100.800.000.352 = 298.000. Rs. for his education expenses .000 PVIFA (12 %. 5 years) = PVIFA (12%.000 – 7.605 40. How long will his son get the amount ? Solution: Let `n’ be the number of years for which a sum of Rs.060 Using a linear interpolation we get 8.000. n) = Rs.000 x PVIFA (9%.786 PVIFA (9%.100.000.060 – 7. The loan will be amortised in five equal instalments.111 – 3. x 1 = 14. Your company is taking a loan of 1.000 PVIFA (9%.000 / Rs.605 n = 5 + ----------------. carrying an interest rate of 15 percent.000 = 4 From the tables we find that PVIFA (12%. 400.000 = 8 .000 can be withdrawn annually. n) = Rs. n) = Rs.78 years 4.400.

You want to borrow Rs.785 554.000.465 (*) rounding off error 42. You approach a housing company which charges 10 percent interest.093 170.685.554. Anurag Limited borrows Rs.367 .332.540 220* Year -----1 2 3 4 5 Interest ----------240.578 681.215 1.329 Principal Balance repayment 150.671 Instalment 298.535 59.785 Principal repaid ------------314.790 495.671 127.000.000 / PVIFA(12%.540 Annual installment --------------554.332.5 7.790 495.215 1. What should be the maturity period of the loan? Solution: Let n be the maturity period of the loan.605 = Rs.2.000 851.000.685.3.Loan Amortisation Schedule Year 1 2 Beg.000 202. 1. The loan is to be repaid in 5 equal annual instalments payable at the end of each of the next 5 years. 400.866 442.000 / 3.000.329 = 0. n) From the tables we find that PVIFA (10%.751 170.785 554.785 554.000 7.329 298. Prepare the loan amortisation schedule Solution: Equated annual installment = 2.656 937. You can pay Rs.572 or 57.329 851.785 352. n) PVIFA (10%.000.2% Interest 41.785 554.226 159.14 years) = = = 3.400.000 148.000.000 per year toward loan amortisation.000 1.656 937.559 394.000 x PVIFA(10%.000.000 to buy a flat.578 / 298.785 Loan Amortisation Schedule Beginning amount ------------2.000 at an interest rate of 12 percent.919 112.250 495320 Remaining balance ------------1. The value of n can be obtained from the equation.5) = 2.

333 7.3500 and it is expected to increase at the rate of 8 percent per year. 600.56 years You want to borrow Rs. You can pay Rs.367 43.606 – 7.000 tons of iron ore per year for 20 years. What is the present value of the iron ore that you can mine if the discount rate is 15 percent Solution: Expected value of iron ore mined during year 1= 160.000.000.422 x 5 = 24. You are negotiating with the government the right to mine 160.560 million x .963 = = = = 5. 15 years) = Using a linear interpolation we get 7.000 x PVIFA(11%.367 n = 14 + ----------------7.000 8. What should be the maturity period of the loan? Solution: Let n be the maturity period of the loan.606 x 1 = 14. 7.963 n = 20 + ----------------8. n) PVIFA (11%.422 – 7.PVIFA (10 %.5. n) From the tables we find that PVIFA (11%.000x3500 = Rs.000 per year toward loan amortisation. The value of n can be obtained from the equation.963 8.000 to buy a flat. 25 years) Using linear interpolation we get 8.500 – 7.333 – 7.600.560 million Expected present value of the iron ore that can be mined over the next 20 years assuming a price escalation of 8% per annum in the price per ton of iron 1 – (1 + g)n / (1 + i)n -----------------------i-g = Rs.03 years 44. You approach a housing company which charges 11 percent interest. The current price per ton of iron ore is Rs.20 years) PVIFA (11 %.

100. 2.560 million x 1 – (1.960 million Expected present value of the iron ore that can be mined over the next 25 years assuming a price escalation of 7% per annum in the price per ton of iron 1 – (1 + g)n / (1 + i)n -----------------------i-g 1 – (1. 32.08 = Rs.000 45.18)25 0.000 (b) PV = 2. Rs. 833. Rs.220 . You are negotiating with the government the right to mine 300.08)20 / (1. As a winner of a competition.000 tons of iron ore per year for 25 years.000 (c ) PV = 100.000 now b.560 million x 10.960 million x 8.15)20 0.0.808.= Rs.721.800.3200 and it is expected to increase at the rate of 7 percent per year.960 million x = Rs. The current price per ton of iron ore is Rs.7.07 = Rs.000 x 6.333 (d) PV = 130.404 = Rs. 130.000 at the end of 8 years c.000.5.688. Rs.194 = Rs.000/0.000x3200 = Rs.07)25 / (1.000PVIF12%.000 x 0.3036 = Rs.15 – 0.960 million x = Rs. you can choose one of the following prizes: a.000.971.805. 800.12yrs = 130.000 next year and rising thereafter by 8 percent per year forever.000 46. What is the present value of the iron ore that you can mine if the discount rate is 18 percent Solution: Expected value of iron ore mined during year 1= 300.8yrs = 2.000 per year for 12 years e. Rs.000 PVIFA12%. Rs.18 – 0.000/r = 100.12 = Rs.2173 = Rs.000 a year forever d. which prize has the highest present value? Solution: (a) PV = Rs. If the interest rate is 12 percent.456.000.

Petrolite owns an oil pipeline which will generate Rs. but the production will fall by 6 percent per year.000/(0.04)] = Rs.5 million 1+g n 1 . What is the present value of the well's production if the discount rate is 15 percent? . The volume of oil shipped. however. If the pipeline is scrapped after 10 years.96 x 5. a.26 million 1+g n 1 .15 – (-0.604 million 48. 20 million of cash income in the coming year.833. The volume of oil shipped.7379 = Rs. If the pipeline is used forever. The discount rate is 18 percent. If the pipeline is scrapped after 30 years. hence. what is the present value of its cash flows? Solution: (a) PV = c/(r – g) = 15/[0.12-0. The discount rate is 15 percent.800.(e) PV = C/(r-g) = 32. cash flows will decrease by 4 percent per year.94 x 3.52. what is the present value of its cash flows? Solution: (a) PV = c/(r – g) = 20/[0.g (b) = 15 x 0.2398 = Rs. will decline over time and. An oil well presently produces 80. Presently the price of oil is $80 per barrel. Oil India owns an oil pipeline which will generate Rs.08) = Rs. If the pipeline is used forever. 15 million of cash income in the coming year.06)] = Rs.100. It has a very long life with virtually negligible operating costs. Rs. however. It will last for 20 years more.704 million 49.------1+r PV = A(1+g) ----------------r.000 Option c has the highest present value viz.------1+r PV = A(1+g) ----------------r. what is the present value of its cash flows? b.333 47. a. will decline over time and. cash flows will decrease by 6 percent per year. Oil prices are expected to increase by 5 percent per year.000 barrels per year. what is the present value of its cash flows? b.62. It has a very long life with virtually negligible operating costs.18 – (-0.105. hence.g (b) = 20 x 0.

How much should be the value of his investments when Vikas turns 60.1. (i) Once he retires at the age of 60. You agree with his assessment. Vikas seeks your help in answering several questions given below.000 per year in the last 5 years of his life to a charitable cause. Further.987 / 1.------1+r PV = A(1+g) ----------------r. His present salary is Rs. to meet this retirement need? (ii) How much should Vikas save each year for the next 20 years to be able to withdraw Rs. Each donation would be made at the beginning of the year. As an investment advisor.000 per year.800.000 per year for his consumption needs from his investments for the following 15 years (He expects to live upto the age of 75 years).000.000 in the bank. Each annual withdrawal will be made at the beginning of the year.013)x 1 – (0.1 = .000 per year from the beginning of the 21st year ? Assume that the savings will occur at the end of each year.g = (80.0.15)20 0. In answering these questions.500.0. you have been approached by a client called Vikas for your advice on investment plan. How much should he have in his investment account when he reaches the age of 60 to meet this need for donation and bequeathing? .15 + 0.756 MINICASE 1 1.06)(1 +0.05) . he wants to bequeath Rs. Vikas has decided to invest his bank balance and future savings in a balanced mutual fund scheme that he believes will provide a return of 9 percent per year. ignore the tax factor.000 x 80) x ( 1-0. g = (1. he would like to withdraw Rs. He is currently 40 years old and has Rs.013 Present value of the well’s production = 1+g n 1 . He expects his salary to increase at the rate of 12 percent per year until his retirement.Solution: The growth rate in the value of oil produced.930.000 to his son at the end of his life.600.013 = $ 36. (iii) Suppose Vikas wants to donate Rs.800. He plans to work for 20 years more and retire at the age of 60.500.

400 So.000 x 8.000 x 3. 9yrs) when he turns 60 This works out to: 1.656 (iii) 60 69 70 71 72 A A A 73 A 74 A 75 1. Solution: (i) This is an annuity due Value of annuity due = Value of ordinary annuity (1 + r) The value of investments when vikas turns 60 must be: 800.460 = Rs.000.700 .400 = Rs. and his salary is paid annually.09 = 800.060 x 1. His current capital of Rs. For the sake of simplicity.7.7. 15 years) x 1.665.000 x PVIFA (9%.028.700 To meet his bequeathing objective he will need 1.3.362.000 x 0.169.000 x FVIF (9%.(iv) Vikas is curious to find out the present value of his lifetime salary income.000 x PVIFA (9%.920 A = 3.000. 5yrs) x PVIF (9%.160 = 3.092. assume that his current salary of Rs.320 – 3.320 (ii) He must have Rs.275 = Rs.000 will grow to: Rs.71. if the discount rate applicable to the same is 7 percent? Remember that Vikas expects his salary to increase at the rate of 12 percent per year until retirement. This means he will need 500.028. 20yrs) = 600.920 A x 51.000 will be paid exactly one year from now.500.3.000 So.362. 9yrs) when he turns 60. his need for donation and bequeathing is: 894.920 A x FVIFA (9%.3.1. what he saves in the next 15 years must cumulate to: 7.665.800 at the end of the 20th year.000 To meet his donation objective.665. What is the present value of his life time salary income.000 = Rs. This works out to: 500.000 x PVIFA (9%.920/51.09 = Rs.700 + 275.000 x 5.000 x PVIF (15%. 5years) when he turns 69. 20 yrs) = Rs.604 = Rs.600.890 x 0.600.000. Vikas will need an amount equal to: 500.894.665.275.160 = Rs.

(iv)

1-

(1+g)n (1+r)n r–g

PVGA = A (1+g)

Where A(1+g) is the cash flow a year from now. In this case A (1+g) = Rs.500,000, g = 12%, r = 7%, and n = 20 So, (1.12)20 1(1.07)20 PVGA = 500,000 0.07 – 0.12 = Rs.14,925,065

MINICASE 2 2. As an investment advisor, you have been approached by a client called Ravi for advice on his investment plan. He is 35 years and has Rs.200, 000 in the bank. He plans to work for 25 years more and retire at the age of 60. His present salary is 500,000 per year. He expects his salary to increase at the rate of 12 percent per year until his retirement. Ravi has decided to invest his bank balance and future savings in a balanced mutual fund scheme that he believes will provide a return of 9 percent per year. You concur with his assessment. Ravi seeks your help in answering several questions given below. In answering these questions, ignore the tax factor. (i) Once he retires at the age of 60, he would like to withdraw Rs. 900,000 per year for his consumption needs for the following 20 years (His life expectancy is 80years).Each annual withdrawal will be made at the beginning of the year. How much should be the value of his investments when he turns 60, to meet his retirement need? (ii) How much should Ravi save each year for the next 25 years to be able to withdraw Rs.900, 000 per year from the beginning of the 26th year for a period of 20 years? Assume that the savings will occur at the end of each year. Remember that he already has some bank balance. (iii) Suppose Ravi wants to donate Rs.600, 000 per year in the last 4 years of his life to a charitable cause. Each donation would be made at the beginning of the year. Further he wants to bequeath Rs. 2,000,000 to his daughter at the end of his life.

How much should he have in his investment account when he reaches the age of 60 to meet this need for donation and bequeathing? (iv) Ravi wants to find out the present value of his lifetime salary income. For the sake of simplicity, assume that his current salary of Rs 500,000 will be paid exactly one year from now, and his salary is paid annually. What is the present value of his lifetime salary income, if the discount rate applicable to the same is 8 percent? Remember that Ravi expects his salary to increase at the rate of 12 percent per year until retirement. Solution: (i) 900,000 x PVIFA ( 9 %, 20 ) x 1.09 900,000 x 9.128 x 1.09 = Rs. 8,954,568 (ii) Ravi needs Rs. 8,954,568 when he reaches the age of 60. His bank balance of Rs. 200,000 will grow to : 200,000 ( 1.09 )25 = 200,000 ( 8.623 ) = Rs. 1,724,600 This means that his periodic savings must grow to : Rs. 8,954,568 - Rs. 1,724,600 = Rs. 7,229,968 His annual savings must be: 7,229,968 A = FVIFA ( 25, 9% ) = (iii) 75 76 Rs. 85,359 = 84.701 7,229,968

600 600 600 600 2000 Amount required for the charitable cause: 600,000 x PVIFA ( 9% , 4yrs ) x PVIF ( 9%, 15yrs ) = 600,000 x 3.240 x 0.275 Rs. 534,600 Amount required for bequeathing 2,000,000 x PVIF ( 9%, 20yrs ) = 2,000,000 x 0.178 = Rs.356,000

(iv) A(1+g) 0 1 ( 1 + g )n PVGA = A(1+ g) 1 ( 1 + r )n r - g ( 1.12 )25 = 500,000 1 ( 1.08 )25 0.08 - 0.12 = Rs. 18,528,922 A ( 1 + g )n n

CHAPTER 7 1. The price of a Rs.1,000 par bond carrying a coupon rate of 8 percent and maturing after 5 years is Rs.1020. (i) What is the approximate YTM? (ii) What will be the realised YTM if the reinvestment rate is 7 percent?

Solution: (i) 80 + (1000 – 1020) / 5 YTM ~ 0.6 x 1020 + 0.4 x 1000 (ii) The terminal value will be 80 x FVIFA (7%, 5yrs) + 1000 80 x 5.751 + 1000 = 1460.08 The realised YTM will be: 1460.08 1020
1/5

=

7.51%

– 1 = 7.44%

2.

The price of a Rs.1,000 par bond carrying a coupon rate of 7 percent and maturing after 5 years is Rs.1040. (i) What is the approximate YTM? (ii) What will be the realised YTM if the reinvestment rate is 6 percent?

Solution: (i) The approximate YTM is: 70 + (1000 – 1040)/5 = 0.0605 or 6.05 percent 0.6 x 1040 + 0.4 x 1000 (ii) 0 -1040 1 70 2 70 3 70 4 70 5 70 1000

The terminal value at 6 percent reinvestment rate is: 70 x FVIFA (6%, 5yrs) + 1000 70 x 5.637 + 1000 = Rs.1394.59 1394.59 1/5 Realised yield to maturity = – 1 = 6.04% 1040 3. A Rs.1000 par value bond, bearing a coupon rate of 12 percent will mature after 6 years. What is the value of the bond, if the discount rate is 16 percent?

Solution: P = 6 ∑ t=1 120 + (1.16)t (1.16)6 1000

= Rs.120 x PVIFA(16%, 6 years) + Rs.1000 x PVIF (16%, 6 years) = Rs.120 x 3.685 + Rs.1000 x 0.410 = Rs. 852.20

4.

A Rs.100 par value bond, bearing a coupon rate of 9 percent will mature after 4 years. What is the value of the bond, if the discount rate is 13 percent?

Solution: 4 ∑ t=1 9 + (1.13)t (1.13)4 100

P =

= Rs.9 x PVIFA(13%, 4 years) + Rs.100 x PVIF (13%, 4 years) = Rs.9 x 2.974 + Rs.100 x 0.613 = Rs. 88.07 5. The market value of a Rs.1,000 par value bond, carrying a coupon rate of 10 percent and maturing after 5 years, is Rs.850. What is the yield to maturity on this bond?

Solution: The yield to maturity is the value of r that satisfies the following equality. 5 100 1,000 + Rs.850 = ∑ t=1 (1+r) t (1+r)5 Try r = 14%. The right hand side (RHS) of the above equation is: Rs.100 x PVIFA (14%, 5 years) + Rs.1,000 x PVIF (14%, 5 years) = Rs.100 x 3.433 + Rs.1,000 x 0.519 = Rs.862.30 Try r = 15%. The right hand side (RHS) of the above equation is: Rs.100 x PVIFA (15%, 5 years) + Rs.1,000 x PVIF (15%, 5years) = Rs.100 x 3.352 + Rs.1,000 x 0.497 = Rs.832.20 Thus the value of r at which the RHS becomes equal to Rs.850 lies between 14% and 15%. Using linear interpolation in this range, we get 862.30 – 850.00 Yield to maturity = 14% + 862.30 – 832.20

x 1%

= 14.41%

6.

The market value of a Rs.100 par value bond, carrying a coupon rate of 8.5 percent and maturing after 8 years, is Rs.95. What is the yield to maturity on this bond?

Solution: The yield to maturity is the value of r that satisfies the following equality. 8 8.5 100 ∑ + t=1 (1+r) t (1+r)8

95 =

Try r = 10%. The right hand side (RHS) of the above equation is: 8.5 x PVIFA (10%, 8 years) + Rs.100 x PVIF (10%, 8 years) = Rs.8.5 x 5.335 + Rs.100 x 0.467 = Rs.92.05 Try r = 9%. The right hand side (RHS) of the above equation is: 8.5 x PVIFA (9 %, 8 years) + Rs.100 x PVIF (9%, 8years) = 8.5 x 5.535 + Rs.100 x 0.502 = 47.04 + 50.20 = 97.24 Thus the value of r at which the RHS becomes equal to Rs.95 lies between 9% and 10%. Using linear interpolation in this range, we get 97.24 – 95.00 97.24 – 92.05

Yield to maturity = 9 % + = 9.43 % 7.

x 1%

A Rs.1000 par value bond bears a coupon rate of 10 percent and matures after 5 years. Interest is payable semi-annually. Compute the value of the bond if the required rate of return is 18 percent.

Solution: 10 ∑ t=1 50 1000

P =

+ (1.09) t (1.09)10

= 50 x PVIFA (9%, 10 years) + 1000 x PVIF (9%, 10 years) = 50 x 6.418 + Rs.1000 x 0.422 = Rs. 742.90

20 years) = 6 x 11.26 + (98-80)/8 -------------------0.91% 5.6 x 80 + 0.34) =Rs.100 par value bond bears a coupon rate of 8 percent and matures after 10 years.100. 20 years) + Rs. What is your post-tax yield to maturity from these bonds? Solution: The post-tax interest and maturity value are calculated below: Bond A Bond B * * Post-tax interest (C ) 11(1 – 0.6x 70 + 0.06)20 100 P = = 4 x PVIFA (6%.94 + (97 – 70)/9 ---------------------0. Interest is payable semi-annually. using the approximate YTM formula is calculated below Bond A : Post-tax YTM = = Bond B : Post-tax YTM = = .06) t (1.97 Post-tax maturity value (M) 100 [ (100-80)x 0. Solution: 20 ∑ t=1 4 + (1.4 x 97 11.100 x 0.100 par value Bond A 11% 8 yrs Rs.70 Your income tax rate is 34 percent and your capital gains tax is effectively 10 percent.34) =Rs.1] =Rs. Compute the value of the bond if the required rate of return is 12 percent.312 = Rs.1] =Rs.06 % The post-tax YTM.4 x 98 10.8.98 7. You are considering investing in one of the following bonds: Coupon rate Maturity Price/Rs.26 9 (1 – 0.7.02 9.5. A Rs.470 + Rs.94 100 [ (100 – 70)x 0.80 Bond B 9% 9 yrs Rs. Capital gains taxes are paid at the time of maturity on the difference between the purchase price and par value.100 x PVIF (6%.

4 x 993 9.1] =Rs. using the approximate YTM formula is calculated below 80.53.6x 860 + 0.6 1000 [ (1000 – 860)x 0.33) =Rs.1000 par value 7 yrs Rs.4 x 986 8.6 x 930 + 0. 993 The post-tax YTM.10.40 + (993-930)/7 -------------------0.1] =Rs. Capital gains taxes are paid at the time of maturity on the difference between the purchase price and par value. You are considering investing in one of the following bonds: Coupon rate Bond A 12% Bond B 8% Maturity Price/Rs.986 * Post-tax maturity value (M) 1000 [(1000-930) x 0. 860 Your income tax rate is 33 percent and your capital gains tax is effectively 10 percent. What is your post-tax yield to maturity from these bonds? Solution: The post-tax interest and maturity value are calculated below: Bond A * Post-tax interest (C) 120(1 – 0.36 % 53.6 + (986 – 860)/5 ---------------------0.80.66 % Bond A : Post-tax YTM = = Bond B : Post-tax YTM = = .33) =Rs. 930 5 yrs Rs.40 Bond B 80 (1 – 0.

10) + Rs.07) t (1.100 x 0.106 + Rs.394 = Rs. The dividend is expected to grow at a constant rate of 8 percent in the future.29 (1.06)16 = Rs.15 Po = D1 / (r – g) = Do (1 + g) / (r – g) = = Rs.70 x 10.3. the market price at the end of the 3rd year will be: P2 = = Po x (1 + g)3 = Rs.11. If the appropriate discount rate is 12 percent. 16) = Rs. what price should the bond command in the market place? Solution: P = 16 ∑ t=1 70 1000 + (1. and carry a coupon rate of 10 percent payable semi-annually. what price should the bond command in the market place? Solution: P = 10 ∑ t=1 5 100 + (1.06) t (1. mature in 8 years.15 .92 12.100.100 x PVIF (7%. How much should this stock sell for now? Assuming that the expected growth rate and required rate of return remain the same.70 x PVIFA(6%. 10) = Rs.42 13.31 . mature in 5 years.00 last year.08. The share of a certain stock paid a dividend of Rs. r = 0. at what price should the stock sell 3 years hence? Solution: Do = Rs. 58. 85. If the appropriate discount rate is 14 percent.0.5 x 7.00.1000 x PVIF (6%. and carry a coupon rate of 14 percent payable semi-annually.46. A company's bonds have a par value of Rs.08) / (0.29 Assuming that the growth rate of 8% applies to market price as well.08) Rs. A company's bonds have a par value of Rs.1000.07)10 = Rs.3.5 x PVIFA(7%.46.08)3 Rs. 1101.3.024 + Rs. 16) + Rs.00 (1.1000 x 0. The required rate of return on this stock is considered to be 15 percent. g = 0.508 = Rs.

1200 = Rs.15)4 Rs.12 – g) 0. r = 0.12 –g = 25/1200 = 0.10 / (0.15) / (0.92 % . 669.25.383.00 last year.14 – g) 0. The equity stock of Amulya Corporation is currently selling for Rs. What is the expected growth rate of Amulya Corporation? Solution: Po = D1 / (r – g) Rs.0.33 Assuming that the growth rate of 15% applies to market price as well.1043or 10.1200 per share. The dividend expected next is Rs.15.0208 = 0. the market price at the end of the 4th year will be: P2 15. Assume that the constant growth model applies to Hansa Limited. The investors' required rate of return on this stock is 14 percent.280 per share.14-0.0992 or 9.14 –g = 10/280 = 0. What is the expected growth rate of Hansa Limited? Solution: Po = D1 / (r – g) Rs. The investors' required rate of return on this stock is 12 percent.00. at what price should the stock sell 4 years hence? Solution: Do = Rs. The dividend is expected to grow at a constant rate of 15 percent in the future. The dividend expected next is Rs.87 The equity stock of Hansa Limited is currently selling for Rs. The required rate of return on this stock is considered to be 18 percent.00.43 % 16.33 (1.0208 g = 0. g = 0.280 = Rs.0357 = 0.383.0357 g = 0.10.18 Po = D1 / (r – g) = Do (1 + g) / (r – g) = = Rs.25 / (0. The share of a certain stock paid a dividend of Rs.00.12-0. How much should this stock sell for now? Assuming that the expected growth rate and required rate of return remain the same.10.15) Rs.14.00 (1.10. = = Po x (1 + g)4 = Rs.18 .10. Assume that the constant growth model applies to Amulya Corporation.

what rate of return do investors expect from the stock of Mammoth Limited? Solution: Po = D1/ (r – g) = Do(1+g) / (r – g) Do = Rs. (i) Assume that the dividend per share will grow at the rate of 20 percent per year for the next 5 years.10 = 0.05 = 0.00.00 on an earnings per share of Rs.00 (1.00.10 Do So 10 = 2.008 or 0.00.10) / (r-(-.10.00 (1. 30. If the current market price is Rs.2.19 – 0.05) r +0.7 / (r + . The current dividend on an equity share of Omega Limited is Rs.00.10.05. what rate of return do investors expect from the stock of Sloppy Limited? Solution: Po = D1/ (r – g) = Do(1+g) / (r – g) = Rs.14 18. Po = Rs.05 =1.00. The previous dividend was Rs.25.8 percent 19.8.17.05) / (r-(-.90 / (r + . What is the intrinsic value of Omega’s equity share? Solution: . Investors require a return of 15 percent from Omega’s equity shares. The earnings and dividends are expected to decline at the rate of 5 percent. the growth rate is expected to fall and stabilise at 12 percent. Mammoth Corporation is facing gloomy prospects.108 r = 0.7/25 = 0..3.19 r = 0. g = -0.90/10 = 0.108 – 0.10)) = 2.00.25 So 25 = 3.10) r +0. The earnings and dividends are expected to decline at the rate of 10 percent.05)) = 1.. If the current market price is Rs. Thereafter.2. Sloppy Limited is facing gloomy prospects.3. g = -0.00. Po = Rs. The previous dividend was Rs.10 =2.

60 1. Thereafter.12 9.12 = 20.12 )] = 0.15 . 9.1 (1 + g2 ) x r .20 .12) x ( 1. 352 The current dividend on an equity share of Magnum Limited is Rs.g2 1 ( 1 + r )n = 45.20) = Rs. 415.gn)] P0 = r . Rs. n = 5 yrs .12) + 2.02 (ii) Assume that the growth rate of 20 percent will decline linearly over a five year period and then stabilise at 12 percent.4.0.15 + 0.0.5 ( 0.15 .60 1+ g1 1Po = D1 1+ r + r .0.g1 = 20 %. (i) Assume that Magnum’s dividend will grow at the rate of 18 percent per year for the next 5 years.20)4 (1.0.49 = Rs.60 ( 1. g2 = 12 %. Equity investors require a return of 15 percent from Magnum’s equity shares.g1 1. What is the intrinsic value of Omega’s share if the investors’ required rate of return is 15 percent? Solution: D0 [ ( 1 + gn) + H ( ga . What is the intrinsic value of Magnum’s equity share? . the growth rate is expected to fall and stabilise at 10 percent.15 .00.53 + 369.20 0.15)5 1 5 n D1 (1 + g1)n .20 1 = 9.gn 8 [ (1. r = 15% D1 = 8 (1.

15 – 0.4.10 4.18) = Rs. r = 15% D1 = 4 (1.100.15 – 0. g2 = 10%.8 .15 – 0.74 + 0.18 = 21.72 (1.10 = Rs.15)5 1 5 n D1 (1 + g1) n – 1 (1 + g2) + r – g2 x 1 (1 + r)n (ii) Assume now that the growth rate of 18 percent will decline linearly over a period of 4years and then stabilise at 10 percent .18 – 0.18 11.15 = 4.10) + 2 (0. What is the intrinsic value per share of Magnum.00 0. if investors require a return of 15 percent ? Solution: (1 + gn) + H (ga – gn) P0 = D0 r – gn (1. n = 5 yrs.10) = 4.Solution: g1 = 18%.72 0.12 = 121.62 + 100.72 1 + g1 1– 1+r P0 = D1 r – g1 1.10) x (1.18)4 (1.

970. 20.00 on an earnings per share of Rs. 228. You can buy a Rs. The current dividend on an equity share of Omex Limited is Rs. 5. what will be your yield to maturity? Solution: Terminal value of the interest proceeds = 100 x FVIFA (15%.00. Equity investors require a return of 15 percent from Omex’s equity share.90 1.674.1 (1 + g2 ) x r . n = 4yrs . What is the intrinsic value of Omex’s equity share? (i) Solution: g1 = 18 %. Assume that the dividend will grow at a rate of 18 percent for the next 4 years.15 + 0. If the re-investment rate applicable to the interest receipts from this bond is 15 percent.g1 1.18 )3 ( 1.15)4 1 4 n D1 (1 + g1)n .35 22.90 1+ g1 1Po = D1 1+ r + r .g2 1 ( 1 + r )n = 21. r = 15% D1 = 5 (1.92 = Rs.5) = 100 x 6.20 .20 Redemption value = 1.0.18 0.15 .1000 par value bond carrying an interest rate of 10 percent (payable annually) and maturing after 5 years for Rs.18) = Rs.90 ( 1. g2 = 12 %.18 1 = 5.15 .12 ) x ( 1.12 5. the growth rate is expected to fall and stabilize at 12 percent.0. Thereafter.21. 5.34 + 206.000 Terminal value of the proceeds from the bond = 1.742 = 674.

49 Redemption value = 100 Terminal value of the proceeds from the bond = 191.49/90)1/8 -1 = 0.20 = (1.49 = (191.53 + PVGO So.15 166. The value of r can be obtained from the equation 90 (1 + r)8 r = 191.49 let r be the yield to maturity. The value of r can be obtained from the equation 970 (1 + r)5 r = 1.9 % 24.33 + PVGO 0.674. If the re-investment rate applicable to the interest receipts from this bond is 10 percent.436 = 91.099 or 9.15-0.14 .20/970)1/5 -1 = 0. PVGO = 111. Keerthi Limited is expected to give a dividend of Rs. What is the PVGO? Solution: Po = D1 r–g Po = 5 = Rs. You can buy a Rs.67 = 55.53 % 23.12 Po = E1 + PVGO r Po = 8.67 0.8) = 8 x 11. 166.1153 or 11.let r be the yield to maturity.100 par value bond carrying an interest rate of 8 percent (payable annually) and maturing after 8 years for Rs. The required rate of return on Keerthi’s stock is 15 percent. Keerthi pays out 60 percent of its earnings.5 next year and the same would grow by 12 percent per year forever.90.674. what will be your yield to maturity? Solution: Terminal value of the interest proceeds = 8 x FVIFA (10%.

1 Initial price .16-0.3 next year and the same would grow by 15 percent per year forever.2 x Rs.20. The current price per share is Rs. PVGO = 237. You expect the price per share of Electra stock a year hence to have the following probability distribution.5 + PVGO So.15 Po = E1 + PVGO r Po = 10 + PVGO 0. Adinath pays out 30 percent of its earnings.19 + 0.00.3 x Rs.25.19 0.. You are considering purchasing the equity stock of Electra Limited.22 = Rs.2 Note that the rate of return is defined as: Dividend + Terminal price -------------------------------. 19.5 20 0.2 (a) What is the expected price per share a year hence? (b) What is the probability distribution of the rate of return on Electra 's equity stock? Solution: (a) (b) Expected price per share a year hence will be: = 0. The required rate of return on Adinath’s stock is 16 percent.5 x Rs.3 20 % 0.16 300 = 62.90 Probability distribution of the rate of return is Rate of return (Ri) Probability (pi) 5% 0.3 22 0. 300 0.20 + 0. You expect the dividend a year hence to be Re.5 CHAPTER 8 1.2. Price a year hence Probability Rs. What is the PVGO? Solution: Po = D1 r–g Po = 3 = Rs.5 10 % 0. Adinath Limited is expected to give a dividend of Rs.

on the other hand. The rupee return (dividend plus price change) of these stocks for the next year would be as follows: Economic condition Low growth Stagnation 0.180. The stock of North India Corporation ( NIC).8.00.3 200 0.500 in the equity stock of SIC and Rs.7 % 0. 189 (c) Probability distribution of the rate of return is Rate of return (Ri) Probability (pi) 3.4 40 65 Recession 0. You expect the dividend a year hence to be Re.000 in the equity stock of SIC and Rs.4 % 0.5 x Rs. Both the stocks are currently selling for Rs.2 x Rs.5 (a) What is the expected price per share a year hence? (b) What is the probability distribution of the rate of return on Empire Corporation 's equity stock? Solution: (a) Expected price per share a year hence will be: = 0.2.3 x Rs.6 % 0.5. does well during growth periods.2 4.3 0.1 60 70 60 50 Probability Return on SIC stock Return on NIC stock High growth 0.000 in the equity stock of SIC.5.2. You are considering purchasing the equity stock of Empire Corporation.3 15.175 + 0.100 per share.175 0.2 80 35 Calculate the expected return and standard deviation of: (a) (b) (c) (d) Rs.200 = Rs.500 in the equity stock of NIC.180 + 0. Which of the above four options would you choose? Why? . You expect the price per share of Empire Corporation stock a year hence to have the following probability distribution. Price a year hence Probability Rs.2 180 0.000 in the equity stock of NIC.2.3. The current price per share is Rs. Rs. Rs. Rs. 1.2.5 The stock of South India Corporation (SIC) performs well relative to other stocks during recessionary periods.000 in the equity of NIC.

567.000 50 x 50 = 2.2) = Rs.500 x 0. The probability distribution of the return on 50 shares is: Economic condition High growth Low growth Stagnation Recession Expected return = Return (Rs) 50 x 65 = 3.000.1 + (1.000 –2. 776.2]1/2 = Rs.4 + (3.625 0.4 0.500 x 0.000–2.500.1) + (4.000 x 0.000 Probability 0.850)2 x 0.250 50 x 60 = 3.89 (c) For Rs. 2. The probability distribution of the return on 50 shares is Economic Condition High Growth Low Growth Stagnation Recession Expected return = = Return (Rs) 50 x 40 = 2.2]1/2 = Rs.875 0.000.1 0.850)2 x 0.000 0.4 + (3.3) + (2.500 50x 80 = 4.800 Standard deviation of the return = [(3.000 x 0.4) + (3.000 50x 60 = 3.850 Standard deviation of the return = [(2.500.1 (25x 80) + (25 x 35) = 2.750 x 0.1) + (1.2 (2.1 0.000 –2.500 –2.000 0.4) + (3.1+ (4. 25 shares of SIC’s stock can be acquired.250–2.000 50x 70 = 3.3 0.000 x 0. likewise for Rs.500 50 x 35 = 1. 25 shares of NIC’s stock can be acquired.250 x 0.5.3 + (2.2.4 0.750 Probability 0.Solution: (a) For Rs.800)2 x .850)2 x 0.21 (b) For Rs.800)2 x .2 (3. 50 shares of SIC’s stock can be acquired. 50 shares of NIC’s stock can be acquired.3 + (3.2 .4 (25x 60) + (25x 60) = 3.000 x 0.3) + (3.850)2 x 0.800)2 x .2.800)2 x . The probability distribution of this option is: Return (Rs) Probability (25 x 40) + (25 x 65) = 2.2.3 0.000 –2.750–2.5.3 (25 x 70) + (25x 50) = 3.500– 2.2) Rs.

40 Option `c’ is the most preferred option because it has the highest return to risk ratio.56 = d.4) + (3.000–2.000–2825)2 x 0.3 0.500–2.2000.4 + (3.100x 0.100 3.4 0.100 Probability 0.3 + (3.100–2.Expected return Standard deviation = (2.21 The expected return to standard deviation of various options are as follows : Expected return Standard deviation Expected / Standard Option (Rs) (Rs) return deviation a 2.000 x 0.56 16. For Rs. 2825 = [(2.1 + (2. gives the rate of return on stock of Apple Computers and on the market portfolio for five years .2) = Rs.800 567.1 0. 20 shares of NIC’s stock can be acquired.169.21 3.66 d 2.830)2 x 0.825 169.830 [(2.2) Rs.4 + (3.3000.4) + (3.272.500 3. likewise for Rs.000–2825)2 x 0. The probability distribution of this option is: Return (Rs) (30x 40) + (20x 65) (30 x 60) + (20x 60) (30x 70) + (20x 50) (30x 80) + (20x 35) Expected return = = = = = = Standard deviation = = 2.2.2 ]1/2 Rs.3 + (3.000x 0.1) + (3.000 3.625 –2825)2 x 0.100–2. The following table.500x 0. 30 shares of SIC’s stock can be acquired.89 4.830)2 x 0.625 x 0.2 (2.830)2 x 0.2]1/2 Rs.830 272.850 776.3) + (3.000x 0.67 b 2.1) + (2.100x 0.21 10.875–2825)2 x 0.3) + (3.875 x 0. 4.1 + (3.93 c 2.830)2 x 0.

16 334.8 – (2.RA -21.48 x 5.2 18. Solution: Year 1 2 3 4 5 Sum Mean σM2 RA -13 5 15 27 10 44 8.8 6.2 2.RM) 178.2 = 83.Year 1 2 3 4 5 Return on the stock Apple Computers (%) -13 5 15 27 10 Return Market Portfolio (%) -3 2 8 12 7 (i) What is the beta of the stock of Apple Computers? (ii) Establish the characteristic line for the stock of Apple Computers.8 6.8 334.7 Cov A.8 (RA .8 = 5-1 83.16 17.2 -3.RM -8. The rate of return on the stock of Sigma Technologies and on the market portfolio for 6 periods has been as follows: .76 12.2 RM .8 1.8 134.2 1.1 = 2.RA) (RM .84 46.1 + 2.24 7.76 2.7 (ii) Alpha = = RA – βA RM 8.24 3.24 10.4.48 RM 5.24 134.M = 5-1 RM -3 2 8 12 7 26 5.4.2) = .2 RA .55 Equation of the characteristic line is RA = .RM)2 67.48 = 33.8 -3.36 123.2 (RM .55 βA = 33.

4 / (5-1) ------------------1971.6 -33.96 696.32 237.92 1585.42 Equation of the characteristic line is RA = .196 RM .4 10.6 2358.96 108.4 5.196 x 25.42 + 1.196 (ii) Alpha = RA – βA RM = 27.16 Σ RA = 136 RA = 27.4 5-1 2358.2 -47.2 / (5-1) = 1.2 – (1.8 -3.92 496.6 26.4 -5.12 17.76 31.Period Return on the stock of Sigma Technologies (%) 16 12 -9 32 15 18 Return on the market portfolio (%) 14 10 6 18 12 15 1 2 3 4 5 6 (i) What is the beta of the stock of Sigma Technologies.12 (RM-RM)2 1 2 3 4 5 36 24 -20 46 50 28 20 -8 52 36 8.2 σ M2 = 1971.2 18.8 2.6) = -3.M = RM = 25.36 1128.8 22.? (ii) Establish the characteristic line for the stock of Sigma Technologies Solution: (i) Year RA (%) RM (%) RA-RA RM-RM (RA-RA) x(RM-RM) 21.2 5–1 βA = ΣRM = 128 Cov A.3.

The rate of return on the stock of Omega Electronics and on the market portfolio for 6 periods has been as follows : Period Return on the stock of Omega Electronics (%) 18% 10% -5% 20% 9% 18% Return on the market portfolio (%) 15% 12% 5% 14% -2% 16% 1 2 3 4 5 6 (i)What is the beta of the stock of Omega Electronics? (ii) Establish the characteristic line for the stock of Omega Electronics.35 33.67 -16.67 250 σM = 2 ∑(R0-R0) (RM-RM) = 215 215 RM = 10 CovO.86 RM .RM)2 25 4 25 16 144 36 250 ∑R0 = 70 ∑RM = 60 R0 =11.07 + 0.33 .33 -1.98 (RM .67 8.0 (ii) = 0.67 6.2.65 .86 x 10) = 3.86 Alpha = = RO – βA RM 11.67 – (0.07 Equation of the characteristic line is RA = 3.0 β0 = 50.32 32.33 (RM – RM) 5 2 -5 4 -12 6 (R0 –R0) (RM – RM) 31.0 = 50 5 43.04 37.3.34 83.6. Solution: Period R0 (%) 1 2 3 4 5 6 18 10 -5 20 9 18 RM (%) 15 12 5 14 -2 16 (R0 – R0) 6.M = 5 = 43.

176 – 0.00. r = 0.1.10 = 8.176 3. The risk-free return is 8 percent and the return on market portfolio is 16 percent. Rs.2 (0.07) 0.00 (1.8 .10.05. Stock P's beta is 0.42 The risk-free return is 7 percent and the return on market portfolio is 13 percent.16 – 0. its dividends and earnings are expected to grow at the constant rate of 5 percent.00. If the previous dividend per share of stock P was Rs.2.13 – 0.118 1.08 + 1.44 . 43. g = 0.05 = Rs. what should be the intrinsic value per share of stock P ? Solution: The required rate of return on stock P is: RP = = = RF + βP (RM – RF) 0.3.g) = Do (1+g) / ( r – g) Given Do = Rs. 118 Intrinsic value of share = D1 / (r.1.05) Intrinsic value per share of stock P = 0. If the previous dividend per share of stock X was Rs.3.00.118 – 0.00 (1. its dividends and earnings are expected to grow at the constant rate of 10 percent. 176 Intrinsic value of share = D1 / (r.08) 0. r = 0.g) = Do (1+g) / ( r – g) Given Do = Rs.8 (0. what should be the intrinsic value per share of stock X ? Solution: The required rate of return on stock A is: RX = = = RF + βX (RM – RF) 0.10) Intrinsic value per share of stock X = 0. 15.07 + 0. Stock X's beta is 1.7. g = 0.00.

what is its beta? Solution: The SML equation is RA = RF + βA (RM – RF) Given RA = 18%.67 11. What is the expected return on the market portfolio? Solution: The SML equation is: RX = RF + βX (RM – RF) We are given 0. we have 0.81 % .9. RF = 9%.e.e.1 is 18 percent. what is its beta? = 1.14 = .e.09 + βA (0.1 (RM – 0.1 RM = 0.33 Solution: The SML equation is RA = RF + βA (RM – RF) Given RA = 14%.06) 0.1681 Therefore return on market portfolio = 16.33 10. The risk-free return is 6 percent and the expected return on a market portfolio is 15 percent.03 Beta of stock = 1. RM = 12%. The risk-free return is 5 percent.185 or RM = 0.βA = 0.12 – 0.09 Beta of stock = 1.67 = 1. RF = 6%. If the required return on a stock is 18 percent.09) 0.05) i.05 i.βA = 0. 1.. RM = 15%. we have 0. The risk-free return is 9 percent and the expected return on a market portfolio is 12 percent.06 + βA (0.12 i. If the required return on a stock is 14 percent.18 = 0.05 + 1.15 – 0.18 = . The required return on a stock whose beta is 1.

The required return on the market portfolio is 15 percent.5 (0.10) i.09 or RM = 0. (b) The decrease in the degree of risk-aversion reduces the differential between the return on market portfolio and the risk-free return by one-fourth.18 Therefore return on market portfolio = 18 % 13. (c) The expected growth rate of dividend on stock A decrease to 3 percent..20 . What is the expected dividend per share of stock A next year? What will be the combined effect of the following on the price per share of stock ? (a) The inflation premium increases by 3 percent.e.025 So Rf = 0.11.5 Revised 8% 7.05 or 5%. The required return on a stock whose beta is 0. The price per share of stock A is Rs.5% 3% 1.10 + 0.5 RA =20 % g = 6 % Po = Rs.86 Po = D1 / (r .5 RM = 0.15 – Rf) 0. The risk-free return is 10 percent.06) So D1 = Rs. (d) The beta of stock A falls to1.12.50 is 14 percent.5Rf = 0.5.50 (RM – 0.2 . The required return on the stock is 20 percent. Original Rf RM – Rf g βA 5% 10% 6% 1.20 = Rf + 1. The expected dividend growth on stock A is 6 percent.04 and Do = D1 / (1+g) = 12.14 = 0.36 RA = Rf + βA (RM – Rf) 0. 0.06) = Rs. The beta of stock A is 1.04 /(1.2 Solution: RM = 15% βA = 1. What is the expected return on the market portfolio? Solution: The SML equation is: RX = RF + βX (RM – RF) We are given 0..12.86 = D1 / (0.86.g) Rs.

17 – 0.5 % Price per share of stock A.6 RA =22 % g = 12 % Po = Rs.260.Revised RA = 8 % + 1.5%) = 17 % Price per share of stock A.16 – Rf) 0. The expected dividend growth on stock A is 12 percent. (b) The decrease in the degree of risk-aversion reduces the differential between the return on market portfolio and the risk-free return by one-half.22 . 83.6. (c) The expected growth rate of dividend on stock A decrease to 10 percent..06 or 6%.03 14.2 (7.23.6 (0. The beta of stock A is 1. The required return on the market portfolio is 16 percent.21 RA = Rf + βA (RM – Rf) 0.6Rf = 0. (d) The beta of stock A falls to 1. The required return on the stock is 22 percent.6 Revised 11% 5% 10 % 1.1 Revised RA = 11% + 1. What is the expected dividend per share of stock A next year? What will be the combined effect of the following on the price per share of stock ? (a) The inflation premium increases by 5 percent. given the above changes is .58 0.22 = Rf + 1. The price per share of stock A is Rs.1 (5%) = 16.g) Rs.03) = Rs.12) So D1 = Rs. given the above changes is 11.036 So Rf = 0.12) = Rs.26 and Do = D1 / (1+g) = 26 /(1.36 (1.1 Solution: RM = 16% βA = 1.260 = D1 / (0. Original Rf RM – Rf g βA 6% 10% 12 % 1. 260 Po = D1 / (r .

6% Sum = Product of deviation times probability (1) 1 2 3 4 (2) 0.3(20%) 15.20 0.10 CHAPTER 9 1.30 Return on asset 1 -6% 18% 20% 25% Return on asset 2 12% 14% 16% 20% a.4)2 + 0. What is the covariance between the returns on assets 1 and 2? c.3 (20 –15.4(12%) + 0.98 -0.9)2]½ 13.6% 4.78 0.2(20%) + 0.10) = Rs.3(25%) 10.1(14 –15.2 (20 –10.9)2 + 0.1(14%) + 0.1% Return on asset 2 Deviation of the return on asset 2 from its mean (6) -3.4(12 –15.3 (3) -6% 18% 20% 25% (5) 12% 14% 16% 20% (2)x(4)x(6) 22.09 19.45 42.10 0.4(-6%) + 0. The returns of two assets under four possible states of nature are given below : State of nature 1 2 3 4 Probability 0.4 % σ(R1) = [.165 – 0.9 % 0.9)2 + 0. What is the standard deviation of the return on asset 1 and on asset 2? b.2 0.9% 7.1(18%) + 0.1% 14.4)2 + 0.53 .2 (16 – 15.2(16%) + 0.4% -1.1% 9.4)2 + 0.4)2] ½ = 3.4 0.98% σ(R2) = [.40 0. What is the coefficient of correlation between the returns on assets 1 and 2? Solution: (a) E (R1) = = E (R2) = = 0.4% 0.35 % (b) The covariance between the returns on assets 1 and 2 is calculated below State of nature Probability Return on asset 1 Deviation of return on asset 1 from its mean (4) -16.9)2 + 0.1 0.4(-6 –10.3 (25 –10.21 (1.23.99 1.1 (18 –10. 392.

d. b.4) = 4.9+4 + 11 5 9 + 6 + 3 + 5+ 8 5 10 + 8 + 13 + 7 + 12 5 = 4% B: = 4.4% C: D: = 6.Thus the covariance between the returns of the two assets is 42.5 (4. Assume equiproportional investment. (c) The coefficient of correlation between the returns on assets 1 and 2 is: Covariance12 42. and D over a period of 5 years have been as follows: 1 8% 10% 9% 10% 2 10% 6% 6% 8% 3 -6% -9% 3% 13% 4 -1% 4% 5% 7% 5 9% 11% 8% 12% A B C D Calculate the return on: a.53.98 x 3.53 = = 0. B. C.91 σ1 x σ2 13.2% . A. Solution: Expected rates of returns on equity stock A.5 (4) + 0. The returns of 4 stocks. C and D can be computed as follows: A: 8 + 10 – 6 -1+ 9 5 10+ 6. B.35 2.2% = 10. portfolio of one stock at a time portfolios of two stocks at a time portfolios of three stocks at a time. c. a portfolio of all the four stocks.0% (a) (b) Return on portfolio consisting of stock A = 4% Return on portfolio consisting of stock A and B in equal proportions = 0.

2 x 5 x 6 + 2 x 0.3 x 0.5 x 12 x 8]1/2 = 5.15% (d) 3.2) = 4.3. and ρ34=0.2 x 0.2) +0. 3. C and D in equal proportions = 0.3 x 0. and 4. B and C in equal proportions = 1/3(4 ) + 1/3(4.2 x 0.25(4) + 0.3 x 5 x 8 + 2 x 0.25(4. and σ4=8. A portfolio consists of 4 securities. Assume that a group of securities has the following characteristics : (a) the standard deviation of each security is equal to σA . w3=0.6.6.4) + 0.6 x 5 x 12 + 2 x 0.3 x 0.2 x 0. 2.3 x 0.3 x 0.4.22 x 62 + 0.2.3.25(6. the portfolio variance is: 6wA2 σA2 + 30 wA2 σAB . and all securities are equally weighted. (b) covariance of returns σAB is equal for each pair of securities in the group.2. What is the variance of a portfolio containing six securities which are equally weighted ? Solution: When there are 6 securities.2 x 0.25(10) = 6.4 x 6 x 12 + 2 x 0.82 % 4.22 x 122 + 0. The correlation coefficients among security returns are: ρ12=0. ρ13=0. What is the standard deviation of portfolio return? Solution: The standard deviation of portfolio return is: σp = [w12σ12 + w22σ22 + w32σ32 + σ42σ42 + 2 w1 w2 ρ12 σ1 σ2 + 2 w1 w3 ρ13 σ1 σ3 + 2 w1 w4 ρ14 σ1σ4 + 2 w2 w3 ρ23 σ2 σ3 + 2 w2 w4 ρ24 σ2 σ4 + 2 w3 w4 ρ34 σ3 σ4 ]1/2 = [0. B.3. σ2=6.(c ) Return on portfolio consisting of stocks A. you have 6 variance terms and 6 x 5 = 30 covariance terms. The standard deviations of returns on these securities (in percentage terms) are : σ1=5. ρ24=0.5. The proportions of these securities are: w1=0.4) + 1/3 (6. σ3=12. 1.32 x 82 + 2 x 0.32 x 52 + 0.2.6 x 6 x 8 + 2 x 0. all covariance terms are the same. ρ23=0. and w4=0.3 x 0.2 x 0. As all variance terms are the same. ρ14=0. w2=0.2 x 0.87% Return on portfolio consisting of stocks A.

The following information is given: Expected return for the market Standard deviation of the market return Risk-free rate Correlation coefficient between stock A and the market Correlation coefficient between stock B and the market Standard deviation for stock A Standard deviation for stock B (i) What is the beta for stock A? = 15% = 25% = 8% = 0. 0.M) 600 = σM2 625 .8 = Cov (A.5.Rf) = 8% + 0.M) ⇒ 30 x 25 Cov (A.96 (ii) What is the expected return for stock A ? Solution: E(RA) = Rf + βA (E (RM) . Market Return Aggressive Stock Defensive Stock 5% .96 (7%) = 14.6 = 30% = 24% Solution: ρAM = σM2 = βA Cov (A.8 = 0.M) = 600 = = 0.5% 10% 25% 45% 16% (i) What is the ratio of the beta of the aggressive stock to the beta of the defensive stock? .72% 6. The following table gives an analyst’s expected return on two stocks for particular market returns.M) σA σM 252 = 625 Cov (A.

5/0.5 x –5 + 0.5 x 25 = 15% Market risk premium = 15% .8% = 2.33 (ii) If the risk-free rate is 7% and the market return is equally likely to be 5% and 25% what is the market risk premium? = 0.30 = 8.5 Solution: E (RM) = 0. Market Return 8% 20% Aggressive Stock 2% 32% Defensive Stock 10% 16% (i) What is the beta of the aggressive stock? Solution: 32% .30 = 2.2% Beta = 20% .7% = 8% (iii) What is the alpha of the aggressive stock? Solution: Expected return = 0.5 . The following table gives an analyst’s expected return on two stocks for particular market returns.Solution: 45 – (-5) Beta of aggressive stock = 25 – 5 16 .10 Beta of defensive stock = 25 – 5 Ratio = 2.5 x 5 + 0.5 x 45 = 20% Required return as per CAPM = 7% + 2.7% 7.5 (8%) = 27% Alpha = .

only a week before his untimely demise . 4 million in Cinderella Fashions. 1.5 x 2% + 0.7 and 0. your firm has already been tracking two viz. Talwar Brothers.(ii) If the risk-free rate is 6% and the market return is equally likely to be 8% and 20%. Ashok Exports (A) and Biswas Industries (B)-their betas being 1. the portfolio of shares had to be maintained as they were for the time being. . As the partition among the family members had to wait for one year as per the terms of the will. What is the scope for appreciation in market price of the three stocks-are they overvalued or undervalued? You find that out the three stocks.5 x 32% = 17% Required return = 6% + 8 x 2.5 = 26% Alpha = 17 – 26% = – 9% MINICASE(1) Mr. to answer the following possible doubts.8 million each in Ashok Exports and Biswas Industries and Rs. the market risk premium is 8% (iii) What is the alpha of the aggressive stock? Solution: Expected return on the aggressive stock = 0. For this purpose the senior partner has asked you to prepare a detailed note to him with calculations using CAPM. As per his will this portfolio of stocks were to be inherited by his wife alone .8 respectively.5 x 8% + 0. What is the expected return and risk (standard deviation) of the portfolio? 2. Nitin Gupta had invested Rs.5 x 20% = 14% Since the risk-free rate is 6%. Meanwhile the widow of the deceased was very eager to know certain details of the securities and had asked the senior partner of Talwar Brothers to brief her in this regard. what is the market risk premium? Solution: The expected return on the market portfolio is: 0. The will had stipulated that the job of administering the estate for the benefit of the beneficiaries and partitioning it in due course was to be done by the reputed firm of Chartered Accountants.

Further. .4 7 18 8 16 17 Boom 0. you have obtained the following historical data on the returns of Cinderella Fashions(C): Period Market return (%) Return on Cinderella Fashions (%) -------------------------------------------------1 10 14 2 5 8 3 (2) (6) 4 (1) 4 5 5 10 6 8 11 7 10 15 On the future returns of the three stocks. you are able to obtain the following forecast from a reputed firm of portfolio managers.3 7 30 12 24 26 Required: Prepare your detailed note to the senior partner.3 7 5 15 (10) (2) Normal 0. ------------------------------------------------------------------------------------------------------State of the Probability Returns ( in percentage ) Economy Treasury Ashok Biswas Cinderella Sensex Bills Exports Industries Fashions ------------------------------------------------------------------------------------------------------Recession 0.

8 -11.3)2]1/2 = [ 4.3x24] = 10.7 -20.3(-10-10.3(24-10.6)2 + 0.36+ 0.Solution: (1) Calculation of beta of Cinderella Fashions stock from the historical data Period 1 2 3 4 5 6 7 Return Return Rc-Rc Rm-Rm (Rm-Rm)2 (Rc-Rc) Rc ( % ) Rm ( %) x (Rm-Rm) 14 10 6 5 25 30 8 5 0 0 0 0 (6) (2) (14) (7) 49 98 4 (1) (4) (6) 36 24 10 5 2 0 0 0 11 8 3 3 9 9 15 10 7 5 25 35 ∑Rc=56 ∑Rm=35 ∑ (Rm-Rm)2= 144 ∑ (Rc-Rc)(Rm-Rm)= 196 2 Rc= 8 Rm= 5 σm = 144/6 =24 Cov(c.3x12] = 11.3x(-)2]+ [0.7 E(B)= [0.6)2]1/2 = [ 127.7 13.3(15-11.4 σA.4(8-11.31 +11.1+45.3 12.3 -3.4(16-10.1 -22.9 -0.6 49.2 78.3(12-11.C= -27.4(17-14)2+0.5 .15]1/2 =2.4x17] + [0.4 0.6 E(M)= [0.36 (2) Calculation of expected returns.3x5] + [0.87]1/2 = 13.m) = 196/6= 32.3 0.3x15] + [0.C= 128.4 Boom 0.7)2 ]1/2 = [48.3 -12.1 2.6 σB.4]1/2 = 9.3x26] = 14 σA = [ 0.3x30] = 17.6 Normal 0.7 σB = [0. standard deviations and covariances E(A) =[ 0.4 + 0.7 Beta of Cinderella Fashions βc = 32.4(18-17.2]1/2 = 11.1 Calculation of covariances between the stocks State of the Prob.B = (2)x(3) x (4) (2)x(4)x(5) (2)x(3)x(5) -14.7)2 +0.6 2.3)2 + 0.66+53.7)2+0.6 +43.7 3.3 E(C)= [0.8 +3.3(26-14)2]1/2 = [ 76.4x8] + [0.3 5.3)2 +0.3x(-)10] + [0.89 σM = [0.1 -7.3(5-17.5 0.4x18] +[ 0.94 σc = [0.7/24= 1.6)2+0.4 σA.RA-RA RB-RB RC-RC Economy ability (1) (2) (3) (4) (5) Recession 0.4x16] +[0.11 +4.3(30-17.3(-2-14)2 +0.

3) +(0. So it is also slightly overvalued.7 % on Ashok Exports is slightly less than the required return of 18. its expected return can be expected to go up to the fair return indicated by CAPM and for this to happen its market price should come down.6 % against the required return of 16.4+ 20.7 σp = [ wA2 σA2 + wB2 σB2 + wC2 σC2 + 2 wAwB σA. So it is slightly overvalued.5 %. So it is considerably overvalued.B +2 wBwC σB.C +2 wAwC σA.7-3.4x17.6)= 13.3% is again slightly less than the required return of 12.9 %.1+ 1.7-4. In the case of Biswas Industries stock.8 ) = 12.5 % As the expected return of 17.6 % Required return on Cinderella Fashions = 7 + (7 x 1. as the expected return of 11.6 %.8 βC = 1.2x10.7 βB =0.7) + (0.4x11.7) = 18.1 ( 3) Determining overpricing and underpricing using CAPM βA =1.9 % Required return on Biswas Industries = 7 + (7 x 0.36 ) =16. its expected return can be expected to go up and for this to happen its market price should come down.4 +7. .C]1/2 = [ 15.Expected return and standard deviation of the portfolio E(P) = (0.6]1/2 = 6. In the case of Cinderella Fashions the expected return is 10.36 E(RM) = 14 Rf =7% SML = 7 + (14 -7)xBeta = 7 + 7 x Beta Required return on Ashok Exports = 7 + (7 x 1.

8 million in Best Industries and Rs. Arihant Pharma (A) and Best Industries (B)-their betas being 1. ------------------------------------------------------------------------------------------------------State of the Probability Returns ( in percentage ) on Economy Treasury Arihant Best Century Nifty Bills Pharma Industries Limited ------------------------------------------------------------------------------------------------------Recession 0. your firm has already been tracking two viz.2 6 (10) (8) 15 (8) Normal 0.MINICASE(2) Seth Ratanlal. What is the scope for appreciation in market price of the three stocks-are they overvalued or undervalued? You find that out the three stocks. you are able to obtain the following forecast from a reputed firm of portfolio managers. What is the expected return and risk (standard deviation) of the portfolio? 2.2 and 0. Detailed instructions had been left on how the estate should be shared between the two . to answer the following possible doubts. Further. Meanwhile the young beneficiaries were very eager to know certain details of the securities and had asked the senior partner of the firm to brief them in this regard.6 million in Arihant Pharma. For this purpose the senior partner has asked you to prepare a detailed note to him with calculations using CAPM. the portfolio of shares had to be maintained as they were for the time being. A week before his demise he had taken a fancy to the capital market and had invested a sizeable amount in equity shares.4 6 30 20 (10) 25 . Rs.2 million in Century Limited. once both of them attained the age of majority. As the partition among the siblings had to wait for at least one more year as the girl was still a minor. you have obtained the following historical data on the returns of Century Limited(C): Period Market return (%) Return on Century Limited (%) -------------------------------------------------1 8 10 2 (6) 8 3 12 25 4 10 (8) 5 9 14 6 9 11 On the future returns of the three stocks.4 6 18 12 6 15 Boom 0. specifically.4. Karaniwala and Karaniwala. 1. The will had entrusted the job of administering the estate for the benefit of the beneficiaries and partitioning in due course to the reputed firm of Chartered Accountants. 1.8 respectively. had left his substantial wealth as legacy to his nephew and niece through a will. Rs. who was widower and issueless.

0 +10=14.0) Normal 0.4x20] = -1.4/42.4) σA.2 (27.4 E(M)= [0.B =149.5 1.2 E(C)= [0.4)2+0.1 +44.4x15] + [0.7 +0.4 0.8) σA.4 12.6 104.3 1.4)2]1/2 = [ 37 +8.2)2 +0.m) = 57/5=11.2 σc = [0.4x12] + [0.4x(-) 10] = 3+2.4)2 +0.2x15] + [0.4(25-14.8+8 = 11.2(-8-11.8 σB.4)2+0.4 Beta of Century Limited βc = 11.5 Boom 0.2(-10-17.6 σB = [0.8 (11.4x6] +[0.4(15-14.2) (19.2) (74.1 Calculation of covariances between the stocks State of the Prob.2) 13.4 = 1.5]1/2 = 14.2)2]1/2 = [ 73.2(15-1.8 8.4(6-1.8 4.1) (58.9) Expected return and standard deviations of the portfolio .6 0.4)2]1/2 = [ 100.4) 45.4x30] = -2+7. Solution: (3) Calculation of beta of Century Limited stock from the historical data Period 1 2 3 4 5 6 Return Return Rc-Rc Rm-Rm (Rm-Rm)2 (Rc-Rc) Rc ( % ) Rm ( %) x (Rm-Rm) 10 8 0 1 1 0 8 (6) (2) (13) 169 26 25 12 15 5 25 75 (8) 10 (18) 3 9 (54) 14 9 4 2 4 8 11 9 1 2 4 2 ∑Rc=60 ∑Rm=42 ∑ (Rm-Rm)2=212 ∑ (Rc-Rc)(Rm-Rm)=57 Rc=10 Rm=7 σm2 = 212/5 =42.4 (52.4)2 + 0.2)2+0.1 (40.4(12-11.4(30-17.4 = 0.2)2 +0.5+52]1/2 = 9.2x(-)10] + [0.2)2 + 0.C= (130.2x(-)8] + [0.4x25] = -1.2+12=17.0]1/2 =10.2 E(B)= [0. standard deviations and covariances E(A) =[ 0.Prepare your report.4(18-17.8 0.3+31.4.2x(-)8]+ [0.6+6.4x18] +[ 0.6 +4.4(-10-1.3 (4) Calculation of expected returns.2)2 ]1/2 = [148 + 0.4 σA = [ 0.RA-RA RB-RB RC-RC (2)x(3)x(4) (2)x(4)x(5) (2)x(3)x(5) Economy ability (1) (2) (3) (4) (5) Recession 0.9 σM = [0.2(-8-14.4(20-11.4 +0.C=(90.4 Cov(c.3+65.9]1/2 = 12.

7% Required return on Century Limited= 6 + (8.90. as the expected return is slightly less than the required return of 12.2) +(0.9-7. The exercise price of a call option is Rs.5 ( 3) Determining overpricing and underpricing using CAPM βA =1.4 x Beta Required return on Arihant Pharma = 6 + (8.C +2 wAwC σA.5% As the expected return of 17.4 Rf =6% SML = 6 + (14.0 + 59.1x1.3 ) = 8.6 +1.2 βB =0.1]1/2 = 10.3 + 16.8 ) = 12.3 E(RM) = 14.4x11.5+0.80.4)=8. Solution: .7%.1=13.2 % on Arihant Pharma is slightly more than the required return of 16.2 ) = 16.4 -6)xBeta = 6 + 8.2% σp = [ wA2 σA2 + wB2 σB2 + wC2 σC2 + 2 wAwB σA. So it is slightly undervalued.2) + (0. In a year’s time it can rise by 50 percent or fall by 20 percent.6+4.44 x 0.B +2 wBwC σB. So it is slightly undervalued.1 %.8 βC = 0. Century Limited can be considered as overvalued as its required return is far in excess of the expected return which is likely to drive the market CHAPTER 10 1. its expected return can be expected to go up and for this to happen its market price should go down. A stock is currently selling for Rs.C]1/2 = [ 53.3-13.1% Required return on Best Industries = 6 + (8.44 x 1.E(P) = (0. (i) What is the value of the call option if the risk-free rate is 10 percent? Use the option-equivalent method. In the case of Best Industries stock.5x17. its expected return can be expected to come down to the fair return indicated by CAPM and for this to happen its market price should go up.44 x 0.

7 x 1.31. (i) What is the value of the call option if the risk – free rate is 7 percent ? Use the option – equivalent method.110.06 = Rs.10 Current value = 1.17 56 = 11.63 x 0 = Rs.69 (ii) What is the value of the call option if the risk-free rate is 6 percent? Use the risk-neutral method.8 R = 1.90 ∆= Cu – Cd = (u – d) S u Cd – d Cu B= (u – d) R = 0.5 r = 0.80 E = Rs.17 0. .5 x 0 – 0.7 x 80 30 – 0 u = 1. The exercise price of call option on this share is Rs.11.11.10 30 = 56 d = 0.37 Expected future value of a call 0.10. An equity share is currently selling for Rs 100. In a year’s time it can rise by 30 percent or fall by 10 percent.10 C = ∆S + B 30 = x 80 – 31.8 x 30 = .10 1. Solution: [P x 50%] + [(1 – P) x – 20%] = 6% 50 P + 20 P = 26 ⇒ P = 0.47 2.S0 = Rs.37 x 30 + 0.10 Rs.

5 x 100 . 8.4 x 20 + 0. 20 40 = 0. .42.Solution: S0 = 100. The exercise price of a call option on this share is Rs.4 Expected future value of call 0.55 3.3 x 0 – 0. = u = 1.06 7.4 x 100 B C = = = = 1.94 (ii) What is the value of the call option if the risk-free rate is 6 percent? Use the risk – neutral method. What is the value of the call option if the risk-free rate is 8 percent? Use the option-equivalent method.4 x 1.07 0.5 R = 1.06 = Rs. it can rise by 50 percent or fall by 10 percent.9. = d = 0.10 = 6 == P = 0.6 x 0 = Rs.3. In a year’s time. a. An equity share is currently selling for Rs. Solution: P x 30% + (1-P) x -10% = 6% 30P + 10P . 7.00 Current value = 8 1.06 = = .42.60.9 x 20 0. = Cu – Cd ( u – d) S0 uCd – dCu ( u – d) R S+B E = 110.07 20 – 0 0.70.

06 4. risk free rate is 8%. exercise price is Rs.Solution: S0 = Rs. 60.08 = Rs.14 Rs.27. 5.4 Current value = 1.55 B = (u .d Cu = 20 .6 x 1.Cd = (u .70 Rs.09 What is the value of a put option if the time to expiration is 3 months. if the risk-free rate is 6 percent? Use the risk-neutral method.d) R C = ∆ S + B = 20 / 36 x 60 .27.0.27 x 20 + 0.6) 60 20 36 1.5 x 0 . u = 1.73 x 0 = 5.78 0.9 x 20 = = .9. What is the value of the call option.10 = 6 P = 0. R = 1. E = Rs.60 and the stock price is Rs. d = 0.d ) So u Cd .0 = (0.4 5. Solution: P x 50 % + ( 1 – P ) x -10% = 6 % 50 P + 10P .78 b. The following information is available for a call option: Time to expiration (months) Risk free rate Exercise price Stock price Call price 3 8% Rs. 5.5.27 Expected future value of call 0.08 ∆ Cu .60 Rs.70 ? Hint : Use put-call parity theorem . 70.

0202 70 = Rs. 90.2.3 Expiration period of the call option = 3 months Risk-free interest rate per annum = 8 percent (i) What is the value of the call option? Use the normal distribution table and resort to linear interpolation. σ = 0. t = 0.S0 ert = 14 + 60 e .80 Exercise price = E = Rs.25 E Co = So N (d1) So ln E d1 = σ√t ert N (d2) σ2 + r + 2 t . r = 0.3 . Consider the following data for a certain share: Price of the stock now = S0 = Rs.25 - - 70 = 14 + 60 1.90 Standard deviation of continuously compounded annual return = σ = 0. Solution: S0 = Rs. 80.08.Solution: According to put-call parity theorem P0 = C0 + E . E = Rs.812 5.08 x .

25 = . 1.2336 e 0.0.0.08 x 0.2264 +(0 .0.80 + e 0.023 /.050) [0.So + e rt 90 = 1.0.25 = Rs.577 ) 0.5 7 .750) = 0.25 N ( .0.0.2821 N(d2) = N ( .96 (ii) What is the value of a put option Solution: E Po = Co .0.1178 + ( 0.0.2821 x 0.09 .08 + 2 = 0.0.2743] = 0.727 = .0.577) = 0.727) = 0.2420 .61 = Rs.3 √ 0.0.2912 – 0.20.96 .18 .0.023 / 0.577 .050) [.25 = 22.2743 +( 0.727) Co N (.600) = 0.3 √ 0.550 ) = 0. 10.2336 90 = 80 x 0.25 d2 = d1 .0.2420 N (.2743 N (.2912 N ( -0.700) = 0..577) = .2264 N (.σ √ t N (d1) = N (.2264] = 0.08 x 0.

C0 d1 = S0N(d1) .5 Expiration period of the call option = 3 months Risk – free interest rate per annum = 6 percent (i) What is the value of the call option? Use the normal distribution table given at the end of this booklet and resort to linear interpolation.2960 80 x 0.30) = 0.25 2 0.0. σ = 0.4013 N (-0.2912] 0.05 = 0.55) = 0.0138 [ 0.3821 + 0.0.26.5362) = 0.25 0. 90 Standard deviation of continuously compounded annual return = σ = 0.25) = 0.3821 N (-0.0.50) = 0. 4.06.2912 N (-0.25 = .05 = 0.4013 – 0.0.0.2912 + 0.E N (d2) ert = ln S0 r + σ2 t E + 2 = σ E = Rs.99 .3874 N( . 80 Exercise Price = E = Rs.5362 N(d1) = N ( .2862 .5 = .0.24 Rs. Consider the following data for a certain share.2862 0.3085 – 0.3085 N( .06 + 0.06 x 0.25 -0.6.75 .0138 [ 0. Current Price = S0 = Rs.1178 + 0. Solution: S0 = Rs.2862) N(d2) = C0 = = = N (-0.5 0. 90 t = 0. 80 r = 0.0.25 30.3821] 0.25 t d2 = d1 – σ t = .2862) = 0.5.5362) N (-0.3874 90 x 2960 .

80 + e = Rs.60) = 1 – 0.25 d1 = σ√ t 0.485) = 0.75 .7422 –.06 + 0.7257 N (0.635 N (d1) = N (0. E = Rs.7373 N (d2) = N (0.15.6861 N (0.25 Consider the following data for a certain stock: Price of the stock now = S0 = Rs.6736 + (.45) = 1 – 0.035 N (0.3085 = 0.09/2) 0.635) = 0.05 =110.65) = 1 – 0. 13.150 Exercise price = E = Rs.σ√ t 0.3.140.25 = d2 = d1 .30 Expiration period of the call option = 3 months Risk-free interest rate per annum = 6 percent (i) What is the value of the call option? Use normal distribution table and resort to linear interpolation? Solution: C0 = S0 N(d1) – ln (S0/E) + (r + σ2/2) t E ert N(d2) S0 = Rs.6915 – 0.7373 140 N (0.7422 .140 Standard deviation of continuously compounded annual return = σ = 0.06.035 N (0.7373 – x 0.2743 = 0.98 = 0.25 . 90 .60 – 94.6736) .05 = 0.3√0.06 x 0.635) = 0.485 = 0.6861 .3264 = 0.2578 = 0. σ = 0.7257) . t = 0.06 x 0.069 + (0.150.6861 N (0. r = 0.(ii) What is the value of a put option? Solution: P0 = C0 – S0 + E ert = 4.50) = 1 – 0.6736 C0 = 150 x 0.6915 e.62 = Rs.7257 + (.25 = 0.41 7.485) = 0.

8643 +(1. The risk-free interest rate is 8 percent and the variance of the continuously compounded rate of return on the firm’s assets is 16 percent.2874+0.0.16 x √ 1 ln (1.8643 + 0.05 = 0. These are 1 year discount bonds with an obligation of 6000 in year 1.8643)/0.08 x 1) + (0.(ii) What is the value of the put option? Solution: E P0 = C0 – S0 + ert 140 = 15.8749-0.16 d1 = = 0. What is the present value of Lakshmi Limited’s equity.10) = 1-0.8682 .1185) From the tables N(1.1357 = 0.16/2) ---------------------------------------------√ 0.3. Lakshmi Limited has a current value of 8000.90 8.4 = (0.8643 N(1.4 = 1.003922 = 0.1185 N(d1) = N (1. S0.98 – 150 + e. The face value of its outstanding bonds is 6000. 25 = Rs.8749 By linear extrapolation N(1.1185) = 0. and debt.1185-1. B0? Solution: So = = Vo N(d1) – B1 e –rt N (d2) 8000 N (d1) – 6000 e – 0.06 x .16)/0.08 N(d2) ln (8000 / 6000) + (0.10)(0.333) + 0.15) = 1.1251= 0.

d2

= =

1.1185 0.7185
N (0.7185)

0.4

N (d2) =

From the tables N(0.70) = 1-0. 2420= 0.7580 N(0.75) = 1 – 0.2264 = 0.7736 By linear interpolation N(0.7185) = 0.7580+ (0.7185-0.70)(0.7736-0.7580)/0.05 = 0.7580+0.005772 = 0.7638 So
B0

= = = =

8000 x 0.8682 – (6000 x 0.9231 x 0.7638) 2715 V0 – S0 8000 – 2715 = 5285

MINICASE

On majoring in finance you have got selected as the finance manager in Navin Exports, a firm owned by Navin Sharma a dynamic young technocrat. The firm has been registering spectacular growth in recent years. With a view to broad base its investments, the firm had applied for the shares of Universal Industries a month back during its IPO and got allotment of 5000 shares thereof. . Recently Mr. Sharma had attended a seminar on capital markets organised by a leading bank and had decided to try his hand in the derivatives market . So, the very next day you joined the firm, he has called you for a meeting to get a better understanding of the options market and to know the implications of some of the strategies he has heard about. For this he has placed before you the following chart of the option quotes of Universal Industries and requested you to advise him on his following doubts, based on the figures in the chart. Universal Industries Option Quotes. (All amounts are in rupees) Stock Price :350 Calls Puts Strike Price Jan Feb March Jan Feb 300 50 55 - * 320 36 40 43 3 5 340 18 20 21 8 11 360 6 9 16 18 21 380 4 5 6 43 * A blank means no quotation is available

March 7 23 -

1. List out the options which are out-of-the-money. 2. What are the relative pros and cons (i.e. risk and reward) of selling a call against the 5000 shares held, using (i)Feb/380 calls versus (ii) March 320/ calls ? 3. Show how to calculate the maximum profit, maximum loss and break-even associated with the strategy of simultaneously buying say March/340 call while selling March/ 360 call? 4. What are the implications for the firm, if for instance, it simultaneously writes March 360 call and buys March 320/put? 5. What should be value of the March/360 call as per the Black-Scholes Model? Assume that t=3 months, risk-free rate is 8 percent and the standard deviation is 0.40 6. What should be the value of the March/360 put if the put-call parity is working?
Solution:

1) 2)

Calls with strike prices 360 and 380 are out –of –the- money. (i) If the firm sells Feb/380 call on 5000 shares, it will earn a call premium of Rs.25,000 now. The risk however is that the firm will forfeit the gains that it would have enjoyed if the share price rises above Rs. 380. (ii) If the firm sells March 320 calls on 5000 shares, it will earn a call premium of Rs.215,000 now. It should however be prepared to forfeit the gains if the share price remains above Rs.320. Let s be the stock price, p1 and p2 the call premia for March/ 340 and March/ 360 calls respectively. When s is greater than 360, both the calls will be exercised and the profit will be { s-340-p1} – { s-360- p2 } = Rs. 15 The maximum loss will be the initial investment , i.e. p1-p2 = Rs.5 The break even will occur when the gain on purchased call equals the net premium paid i.e. s-340 = p1 – p2 =5 Therefore s= Rs. 345 If the stock price goes below Rs.320, the firm can execute the put option and ensure that its portfolio value does not go below Rs. 320 per share. However, if stock price goes above Rs. 380, the call will be exercised and the stocks in the portfolio will have to be delivered/ sold to meet the obligation, thus limiting the upper value of the portfolio to Rs. 380 per share. So long as the share price hovers between R. 320 and Rs. 380, the firm will lose Rs. 1 (net premium received) per pair of call and put.

3)

4)

5) S0 = 350 ln 360 d1 = E =360 t =0.25 r = 0.07 σ =0.40 350 + 0.07 + 2 0.40 x √ 0.25 (0.40)2 x 0.25

= ( -0.0282 + 0.0375) / 0.2 = 0. 0465 d2 = 0.0465 -0.40 √¯ 0.25¯ ¯ = -0.1535 Using normal distribution table N (0.00) = 1- 0.5000 = 0.5000 N (0.05) = 1 – 0.4801 = 0.5199 Therefore N( 0.0465) = 0.5000 + (0.0465/0.0500) x (0.5199 – 0.5000) = 0.5185 N ( - 0.20) = 0.4207 N ( -0.15) = 0.4404 Therefore N ( -0.1535) = 0.4207 + ( 0.0465/0.0500) x(0.4404 – 0.4207) = 0.4390 E / ert = 360 / e0.07 x 0. 25 = 360 / 1. 01765 = 353.75 C0 = 350 x 0.5185 – 353.75 x 0.4390 = 181.480 – 155.30 = Rs. 26.18 6) If put- call parity is working, we have P0 = C0 – S0 + E/ert Value of the March/360 put = 26.18 -350 + 353.75 = Rs.29.93

CHAPTER 11

1.

Matrix Associates is evaluating a project whose expected cash flows are as follows:
Year 0 1 2 3 4 Cash flow (Rs. in million) (23) 6 8 9 7

The cost of capital for Matrix Associates is 14 percent. (i) What is the NPV of the project?

Solution:

6 8 9 7 NPV = -23 + -------- + --------- + -------- + --------(1.14) ( 1.14)2 ( 1.14)3 ( 1.14)4 = -23 + 5.263 + 6.156 + 6.075 + 4.145 = -1.361

(ii) What is the IRR of the project?
Solution:

When the discount rate is 14 %, the NPV is -1.361 Trying a lower rate of 12% 6 8 9 7 NPV = -23 + -------- + -------- + -------- + --------(1.12) (1.12)2 (1.12)3 (1.12)4 = -23 + 5.357 + 6.378 + 6.406 + 4.449 = -0.41 Trying a still lower rate of 11% 6 8 9 NPV = -23 + -------- + -------- + -------(1.11) (1.11)2 (1.11)3

7 + ------(1.11)4

= -23 + 5.405 + 6.493 + 6.581+ 4.611 = 0.09 By linear interpolation we get 0.09 IRR = 11 + ------------------ = 11.18% (0.41 + 0.09)

(iii) What is the NPV* of the project if the reinvestment rate is 18 percent?
Solution:

Terminal value = 6(1.18)3 + 8(1.18)2 + 9(1.18) + 7 = 38.617 NPV* = 38.617 / (1.14)4- 23 = -0.136

(iv) What is the MIRR of the project if the reinvestment rate is 18 percent?
Solution:

23 (1+MIRR)4 = 38.617 (1+MIRR)4 = 38.617 / 23 = 1.679 MIRR = (1.679)1/4 – 1 = 13.83% 2. Sigma Corporation is evaluating a project whose expected cash flows are as follows:
Year 0 1 2 3 4 Cash flow (Rs.in million) - 16.0 3.2 4.5 7.0 8.4

The cost of capital for Sigma Corporation is 12 percent . (i) What is the NPV of the project?
Solution:

NPV

=

-16.0

+

3.2 (1.12)

+

4.5 (1.12)2

+

7.0 (1.12)3

+

8.4 (1.12)4

2.8576 + 3.5865 = 0.7705

+ 4.984

+ 5.3424

(ii) What is the IRR of the project?
Solution:

NPV

At 12% discount rate NPV is 0.7705 Try 13% = -16 + 3.2 (0.885) + 4.5 (0.783) = -16 + 2.832 + 3.5235 = 0.3557

+ 7 (0.693) + 4.851

+ 8.4 (0.613) + 5.1492

Try 14% NPV = -16 + 3.2 (0.877) + 4.5 (0.769) + 7 (0.675) = -16 + 2.8064 + 3.4605 + 4.725 = -0.0353 As this is very nearly zero, the IRR of the project is 14 %

+ 8.4 (0.592) + 4.9728

(iii) What is the NPV * of the project if the reinvestment rate is 16%?
Solution:

Terminal Value = = = = NPV* = 3.2 (1.16)3 3.2 (1.561) 4.9952 27.5722 27.5722 (1.12)4 (iv) What is the IRR* if the reinvestment rate is 16%?
Solution:

+ + +

4.5 (1.16)2 4.5 (1.346) 6.057

+

7 (1.16)1

+ + 8.4 + 8.4

8.4

+ 7 (1.16) + 8.12

- 16

= 1.5359

16 ( 1 + 1RR*)4 ( 1 + 1RR*)4 1RR*

= =

27.5722 27.5722 16 = 1.7233

= (1.7233) 1/4 -1 = 1.1457 - 1 = 14.57 %

3.

Dumas Company is evaluating a project whose expected cash flows are as follows:
Year Cash flow 0 - Rs.700,000 1 Rs.150,000 2 Rs.200,000 3 Rs.300,000 4 Rs.350,000 The cost of capital for Dumas Company is 12 percent

(i) What is the NPV of the project?

800 .200 695.900 214.550 711.000 IRR = 13 % + 711.70% (iii) What is the NPV * of the project if the reinvestment rate is 15% ? Solution: Terminal value = 150.000 350.877 0.600 29.000 13% PVIF 0.783 0.000 + 350.550 1.050 711.400 + 345.12)4 = 54.500 207.000 = 228.000 300.693 0.000 = 150.000 1.187.800 .000 0.000 (1.15)3 + 200.000 (1.322) + 300.000 (1.000 200.950 159.797 0.712 0.893 0.000 (1.000 ( 1.550 NPV * = (1.000 133.000 .800 202.636 -700.600 222.Solution: .150 + 264.675 0.700.187.15)2 + 300.592 PV 131.769 0.600 207.000 150.000 350.000 200.885 0.000 (1.613 14% PV 132.700.15)1 + 350.750 156.800 PVIF 0.000 300.050 x 1% = 13.521) + 200.550 (ii) Solution: 150.400 213.150) + 350.709 .695.000 = 1.550 153.700.

550 / 700.000 3 4 210.000 5 130.000 ( 1 + IRR*)4 (1 + IRR*)4 IRR* = 1.000 200.(iv) What is the IRR* if the reinvestment rate is 15%? Solution: 700.10) (1.6965 = (1.(850.51 + 284.017.187.90 = 1017.000 400.16) = 181.80 + 306.000 What is the NPV of the project (in '000s) if the discount rate is 10 percent for year 1 and rises thereafter by 2 percent every year? Solution: 200 PVB = (1.030 5.1413 .6965)¼ .000) 1 120.82 + 243.12) (1.187.14) (1.000.000 360.13% 4.000 2 450.10) + + 300 + (1.030 – 1.550 = 1.000 = 17.000 .1 = 1.12) 500 400 (1.12) (1.000 300. NPV = 1.14) (1. You are evaluating a project whose expected cash flows are as follows: Year 0 1 2 3 4 Cash flow -1.10) (1.000 = 1.03 .1 = 14. The cash flows associated with an investment are given below: Year Cash flow 0 Rs.000.10) (1.000 500.

400(A) Investment = 850.18 (B) Benefit cost ratio(A/B) .240x PVIF (18.000x PVIF (12.430xPVIF (18.650+256.720+34.000 = 1.650(A) Investment = 260.Calculate the benefit cost ratio of this investment.000) 85.160+358.000x PVIF (12.3)+210.5) =107.240 128.000x PVIF (12.(260.560+73.350xPVIF (18.480 78.126+78.000 = 306. 929.420 103.239 = Rs.000 = 1. Solution: PV of benefits (PVB) =120.000x PVIF (12.1)+ 103.420xPVIF (18.000 = 929.4) +130.214+47. Solution: PV of benefits (PVB) =85.09 (B) Benefit cost ratio (A/B) 6. if the discount rate is 18 percent.2) +128.4) +78.320+133.350 Calculate the benefit cost ratio of this investment.2) +360. if the discount rate is 12 percent.3)+ 92.400/850.710 = Rs. 306.1)+450.000x PVIF (12.351+74. The cash flows associated with an investment are given below: Year 0 1 2 3 4 5 Cash flow Rs.480x PVIF (18.650/260.5) =72.430 92.

29 % Project B NPV at a cost of capital of 14% = .34 million IRR (r ) can be obtained by solving the following equation for r.8) = 250 PVIFA (r.8) = Rs.078 r’ = 19%.100 million which will produce an expected cash inflow of Rs. Project A involves an outlay of Rs.98 million IRR (r') can be obtained by solving the equation 25 x PVIFA (r'.078.17 From tables we see that when: r =17 %.63 % . Project B calls for an outlay of Rs. r’ =18 + (4.8) = Rs.-250+ 60x 4.60 million per year for 8 years.25 million per year for 8 years.207-4.15.3.8) =4 From tables we see that when: r’ =18 %. Your company is considering two mutually exclusive projects.954 By extrapolation.7. a. 60 x PVIFA (r.954) = 18. r =17 + (4.207 RHS = 4.8) = 100 PVIFA (r’.100 + 25 x PVIFA (14.639 = Rs.078) = 17.078 By extrapolation.207-4.250 + 60 x PVIFA (14.28.17)/(4. The company's cost of capital is 14 percent. RHS = 3. A and B.250 million which will generate an expected cash inflow of Rs. RHS = 4. RHS = 4. What is the NPV and IRR of the differential project (the project that reflects the difference between Project B and Project A) Solution: (a) Project A NPV at a cost of capital of 14% = .8) =4.078-4)/(4. r = 18%. Calculate the NPV and IRR of each project b.

What is the discounted payback period for each of the projects if the cost of capital is 15 percent? c. (b) . The expected cash inflows from these projects are: Year 1 2 3 4 Project M 85 120 180 100 Project N 100 110 120 90 a. Your company is considering two projects. r’’ =16 + (4.8) = Rs. Project N The pay back period lies between 2 and 3 years. If the two projects are mutually exclusive and the cost of capital is 20 percent. M and N. RHS = 4.207 By extrapolation. Interpolating in this range we get an approximate pay back period of 2.25 years. which project should the firm invest in? e.8) = 4.344 r’’ = 17%.240 million. Interpolating in this range we get an approximate pay back period of 2. RHS = 4.344-4.37 million IRR (r'’) can be obtained by solving the equation 35 x PVIFA (r'’.286 From tables we see that when: r’’ =16 %. NPV of the differential project at 14% = -150 + 35 x PVIFA (14. what is the modified IRR of each project? Solution: Project M The pay back period of the project lies between 2 and 3 years.35 million. which project(s) should the firm invest in? d.4. which project should the firm invest in? f. If the cost of capital is 13 percent.150 million Difference in net annual cash flow between projects A and B is Rs.207) = 16.(b) Difference in capital outlays between projects A and B is Rs. If the two projects are independent and the cost of capital is 15 percent. If the two projects are mutually exclusive and the cost of capital is 12 percent.19 years. What is the payback period for each of the projects? b.344.12. Each of which requires an initial outlay of Rs.286)/(4.8) = 150 PVIFA (r’’.42 % 8.

240 + 100 x0.4) .756 + 180 x0.1) + 120 x PVIF (15.1) + 110 x PVIF (15.3) + 100 x PVIF (15.870+120 x 0.64 years. Interpolating in this range we get an approximate DPB of 2.2) + 180 x PVIF (15.a Year Cash flow PV of cash flow Cumulative PV of cash flow 1 85 73.65 3 180 118.240 + 85 x 0.96 2 110 83. (c ) Project M Cost of capital NPV = = = = Project N Cost of capital NPV 15% per annum .6 million Since the two projects are independent and the NPV of each project is positive.74 164. 100.572 = Rs.4) =.18 170.572 Rs.14 3 120 78. .756 + 120 x 0.90 249.658 + 90 x 0.35 283 4 100 Discounted pay back period (DPB) lies between 2 and 3 years.Cost of capital = Project M 15 % p.a Year Cash flow PV of cash flow Cumulative PV of cash flow 1 100 86.658 + 100 x 0.04 4 90 Discounted pay back period (DPB) lies between 2 and 3 years.96 86.31million = 12% per annum = .240 + 85 x PVIF (15.3) + 90 x PVIF (15.870+ 110 x 0.240 + 100 x PVIF (15.89 years.2) + 120 x PVIF (15.91 73.91 2 120 90. Project N Cost of capital = 15 % p. 60. Interpolating in this range we get an approximate DPB of 2.

56 million 15% per annum Rs. This assumes that there is no capital constraint.59 million Since the two projects are mutually exclusive. MIRR = 24.57 million Again the two projects are mutually exclusive.32.123.e.. (e) Cost of capital = NPV = Project N Cost of capital: NPV = Project M 15% per annum 66.. NOTE: The MIRR can also be used as a criterion of merit for choosing between the two projects because their initial outlays are equal. choose project M. we need to choose the project with the higher NPV i.64 % Project N Terminal value of the cash inflows: 510.35 i. So we choose the project with the higher NPV.79.76 % .35 MIRR of the project is given by the equation 240 ( 1+ MIRR)4 = 510. MIRR = 20.both the projects can be accepted. i.e.. (d) Project M Cost of capital NPV Project N Cost of capital NPV = 12% per annum = Rs. (f) Project M Terminal value of the cash inflows: 579.27 i.e.23 million = 10% per annum = Rs.e.27 MIRR of the project is given by the equation 240 (1 + MIRR)4 = 579.. choose project M.

600. 224.000 and lasts 8 years.50.000 x PVIFA (15.9.2.50.e.8) i. The value of I can be obtained from the following equation 50.000 / 4.000 for 8 years at a discount rate of 15% per annum. The value of NCF can be obtained from the equation NCF x PVIFA (14.000 x 4. . The value of NCF can be obtained from the equation NCF x PVIFA (12.8) NCF = = = 2. If an equipment costs Rs. I 12.639 431. what should be the minimum annual cash inflow before it is worthwhile to purchase the equipment ? Assume that the cost of capital is 12 percent Solution: Let NCF be the minimum constant annual net cash flow that justifies the purchase of the given equipment.000 for 8 years ? Assume that the discount rate is 15 percent.127 11. = I = 50.000. If an equipment costs Rs..000 for 12 years ? Assume that the discount rate is 16 percent.137 10.111 85. How much can be paid for a machine which brings in an annual cash inflow of Rs.000 / 4.000.6) NCF = = = 350.487 = Rs.000.350.350 How much can be paid for a machine which brings in an annual cash inflow of Rs.000 and lasts 6 years.000 2.000 350. what should be the minimum annual cash inflow before it is worthwhile to purchase the equipment ? Assume that the cost of capital is 14 percent Solution: Let NCF be the minimum constant annual net cash flow that justifies the purchase of the given equipment. Solution: Define I as the initial investment that is justified in relation to a net annual cash inflow of Rs.

000 x 5. two models developed by it in the last few years have not done well and were prematurely withdrawn from the market. For the sake of simplicity assume that 50 percent will be incurred right in the beginning and the balance 50 percent will be incurred after 1 year. Term loan and working capital advance will be raised at the end of year 1. After a lengthy discussion.600..400 million. You can assume that the outlay on plant and machinery will be incurred over a period of one year. after the project commences. However. 3. You have been recently hired as the executive assistant to Vijay Mathur.000 for 12 years at a discount rate of 16% per annum.Solution: Define I as the initial investment that is justified in relation to a net annual cash inflow of Rs.e.100 million each. Managing Director of Metaland.118. and Rs. which is the expected life of the project. Vijay Mathur has entrusted you with the task of evaluating the project. . It has a very strong R&D centre which has developed very successful models in the last fifteen years. the board of directors of Metaland decided to carefully evaluate the financial worthwhileness of manufacturing this model which they have labeled Meta 4. The value of I can be obtained from the following equation 600. The interest rate on the term loan will be 14 percent. till they are paid back or retired at the end of 5 years. Meta 4 would be produced in the existing factory which has enough space for one more product.100 million of trade credit.200 CHAPTER 12 MINICASE 1 Metaland is a major manufacturer of light commercial vehicles. Meta 4 project will require Rs. Equity will come right in the beginning by way of retained earnings.12) i.197 = Rs.000 x PVIFA (16 . Meta 4 will require plant and machinery that will cost Rs.200 million toward gross working capital. Rs.200 million of term loan. The term loan is repayable in 8 equal semi-annual instalments of Rs. Working capital advance will carry an interest rate of 12 percent.100 million of working capital advance. Rs. I I = = 600. The proposed scheme of financing is as follows : Rs. The plant will commence operation after one year. The engineers at its R&D centre have recently developed a prototype for a new light commercial vehicle that would have a capacity of 4 tons. You can assume that gross working capital investment will occur after 1 year. The first instalment will be due after 18 months of raising the term loan.200 million of equity. The levels of working capital advance and trade credit will remain at Rs.25 million each.

Solution: Cash Flows from the Point of all Investors Item 0 1 2 3 4 5 6 1.5 180 174. Cash flows from the point of equity investors. For tax purposes. Profit after tax (0.2 367 . b.4 170. The operating costs (excluding depreciation and taxes) are expected to be Rs. Depreciation 6.1 750 525 42. Revenue 4. Terminal cash inflow 13. Vijay Mathur wants you to estimate the cash flows from three different points of view: a.4 170.8 128. Net salvage value of plant and equipment 9. Cash flows from the point of all investors (which is also called the explicit cost funds point of view).0 750 525 31.7 x 6) 8. Profit before tax 7.4 100 100 187.6 193. The net salvage value of plant and machinery is expected to be Rs. Operating costs 5.4 135.5 180 174. Plant and equipment (200) (200) 2. Recovery of net working capital 10.525 million per year. Net working capital (100) 3. Net cash flow (200) (300) 750 525 100 125 87. The income tax rate is expected to be 30 percent.Meta 4 project is expected to generate a revenue of Rs. Initial investment (200) (300) 11.2 167 200 187. Operating cash flow (7 + 5) 12.5 750 525 75 150 105 750 525 56.3 168.750 million per year.2 182. Assume that there is no other tax benefit.100 million at the end of the project life.7 118. Recovery of working capital will be at book value. the depreciation rate on fixed assets will be 25 percent as per the written down value method.

Repayment of working capital advance 13.3 137.3 176.2 750 525 42.2 750 525 56. Operating cash inflows (8 + 4) 16.5 153. Interest on working capital 6. Depreciation 5.2 154.9 .2 152.7 78.5 750 525 75 12 26.3 158. Net salvage value of plant & equipment 10.9 (50) (50) (50) 50 (200) - 159.5 103. Profit after tax 9.6 12 5.4 96.2 204. Liquidation & retirement cash flows (9 + 10 – 13 – 14 – 15) 17. Initial investment (1) 15. Interest on term loan 7.2 102.5 111 750 525 31.3 111. Operating costs 4.2 12 12. Net cash flow (200) 750 525 100 12 28 85 59. Retirement of trade credit 14. Recovery of working capital 11. Repayment of term loans 12. Profit before tax 8.3 12 19.3 100 200 50 50 50 50 100 100 159.5 153.Cash Flows from the Point of Equity Investors Item 0 1 2 3 4 5 6 1.1 123. Revenues 3. Equity funds (200) 2.5 103.

The effective tax rate is 30% Required 1. Operating costs (costs before depreciation. The term loan will carry an interest of 8 percent per annum and will be repayable in 4 equal annual instalments. revenues will decline by Rs. Assume that the investment in net working capital will be made right in the beginning of each year and the same will be fully financed by working capital advance carrying an interest rate of 10 percent per annum.20 million.10 million per year for the following two years. It manufactures a range of bulk drugs.40 million in plant and machinery right in the beginning. Vice President (Finance). The net salvage value of plant and machinery after 5 years is expected to be Rs.50 million in year1 which will rise by Rs. interest.10 million per year for the remaining two years. the first instalment falling due at the end of year 1. At the end of 5 years the working capital is expected to be liquidated at par. It would generate a revenue of Rs. technically called APIs (active pharmaceutical ingredients). After discussing with marketing. and other personnel. For tax purposes. technical. Thereafter. Due to this erosion there will be a loss of Rs. you have gathered the following information. MBD-9 will require an outlay of Rs. The MBD-9 project has an economic life of 5 years. the depreciation rate will be 15 percent as per the written down value method. 2. . MBD-9 is expected to erode the revenues of an existing bulk drug. they may be ignored in the present analysis. Estimate the net cash flows relating to equity over the 5-year period. The same will be financed by equity and term loan in equal proportions. You have been asked to develop the financials for MBD-9. who coordinates the capital budgeting activity. While there may be some other impacts as well.4 million per year by way of contribution margin for 5 years. Max is considering a new bulk drug called MBD-9. Estimate the net cash flows relating to explicit cost funds (investor claims) over the 5-year period.MINICASE 2 Max Drugs Limited is a leader in the bulk drug industry. The net working capital requirement will be 20 percent of revenues. You have recently joined Max as a finance officer and you report to Prakash Singh. and taxes) will be 60 percent of revenues.

0 4. Terminal cash inflow (10 + 11) 15.0 (50.53 2.0 36.01 20.Solution: Net Cash Flows Relating to Explicit Cost Funds 1.1 12.9 4. Fixed assets 2.43 3 2.90 11.90 13. Depreciation 7.53 20.0) (2.14 30.0) 13.0 4. Recovery of working capital 12.0 36.0 18. Tax 9.68 16.0) 1 (2. Loss of contribution margin 6.0 4.0 3.10 2.0 70.87 3.0 4. Revenues 4.0) 15.10 17.0 13.0 3.86 9. Profit before tax 8.0 4.0 4. Net cash flow : 0 (40.0) 11.76 (Rs. Net working capital 3.0 2 (2.0 5.0 60.0 30.66 5.13 12.0 3.0 42.0 10.1 42. Net salvage value of fixed assets 11.0) 60.in million) 4 5 2.34 19.1 14.0 30. Initial outlay & working capital 13.00 (50.0) (10.47 10.0 15. Profit after tax 10.0 (2.0 7. Operating costs 5.42 50.32 4. Operating cash flow (9 + 6) 14.0 6.0) 50.0 10.14 .

72 4. Profit after tax 11.18 (5.0 36.0 5.0 4.46 5.6 7.0) 8.0 1.56 13.0 5.85 16.0 4.75 42.0 3. Interest on working capital advance 7.0) 11. Net salvage value of fixed assets 12. Depreciation 6. Repayment of term loan 14.18 13.1. Initial investment (1) (20. Operating cash flows (10 + 5) 17.in million) 0 1 2 3 (20. Repayment of working capital advance 15.0 30.8 17.0 11.0 6.44 20.0 4.44 .0 4 60.0 5.0 1.4 14.0 70.0 3.2 1.4 2.2 12. Net salvage value of current assets 13.24 12.18 36.0) 16.75 8.31 20.30 5 50.98 (5. Operating costs 4.56 (5.0 4.1 1.0 10.98 11.40 0. Revenues Net Cash Flows Relating to Equity(Rs.5 3.0 4.20 0.22 5.13 1. Loss of contribution margin 5.0 60. Tax 10.68 1. Net cash flow (20.56 8.42 10.85 (5.0 4.34 1.0) 50.87 3.22 5.0) (15+16+17) 30.00 11. Liquidation & retirement cash flows (11 + 12 – 13 – 14) 18. Equity funds 2.0) 8.0 5.0 31. Interest on term loan 8.0 10.0) 6.0 3. Profit before tax 9.

0 million for year 1.80 million and it will be depreciated at the rate of 25 percent per year as per the WDV method for tax purposes.10 million of contribution margin from those preparations.e at the end year 0) will be Rs. M-cin. The sales from this preparation are expected to be as follows: Year 1 2 3 4 5 Sales ( Rs in million) 50 100 150 100 50 • • • • • The capital equipment required for manufacturing M-cin will cost Rs. The expected net salvage value of the capital equipment after 5 years is Rs.4 million and maintenance cost Overhead allocation : 10 percent of sales (excluding depreciation maintenance. The tax rate applicable for this project is 30 percent. This will mean a reduction of Rs. The net working capital requirement for the project is expected to be 25 percent of sales. (a) Estimate the post-tax incremental cash flows of the project viewed from the point of all investors(which is also called the explicit cost funds point of view). is considering the manufacture of a new antibiotic preparation. The manufacture of M-cin would use some of the common facilities of the firm. what additional information would you need ? .50. the net working capital at the beginning of year 1 (i.12.MINICASE 3 Medipharm. (b) To calculate the cash flows from the point of equity investors. for which the following information has been gathered. it is not likely to have any effect on overhead expenses as such.20 million. The net working capital will be adjusted at the beginning of the year in relation to the expected sales for the year. For example. that is 25 percent of the expected revenue of Rs.5 million. a pharmaceutical company. The accountant of the firm has provided the following cost estimates for M-cin : Raw material cost : 40 percent of sales Variable labour cost : 10 percent of sales Fixed annual operating: Rs. The use of these facilities will necessitate reducing the production of other pharmaceutical preparations of the firm. and interest) While the project is charged an overhead allocation . • M-cin is expected to have a product life cycle of five years and thereafter it would be withdrawn from the market.

00 5.00 60.44 10. Sales 5. Variable labour cost 7. Loss of contribution margin 10. NSV of fixed assets 13.7 (12.00) (6.5 100.5 (80) (12. Fixed annual operating cost 8.83 12.00 20.00 4.00 15.67 3.00 15. In NWC 16.00 ( 9.20 58.00 11.5 150. The additional information needed for calculating the cash flow from the point of view of equity investors are: • Equity funds committed to the project • Interest cost on all borrowings • Repayment /retirement schedule of all borrowings and trade creditors • Net salvage value of all current assets • Preference dividend and redemption of preference capital .33 10.Solution: Item 1.29 – – 50.00 40.20 17.5 27.60 32.00 27. Fixed assets 2.5 (12.00 12. Raw material cost 6.73 9.00 4.70 25.56 19.25 10.00 5.58 40. Initial investment in fixed assets 15.00 6.10 b.00 8.0 (12.5) 13.00 10.00 40. Net working capital level 3. Profit after tax 12. Profit before tax 11.00 20.5) 100. Terminal cash flow (12+13) Net Cash Flow Cash Flows from the Point of All Investors 0 1 2 3 4 5 (80) 12. Recovery of NWC at the end 14.5 (92.23 42.00 14.00 4.5) 25.5 12.0 12.5 46.75 34. Investment in net working capital 4.5) 29.00 21.00 10.08 12.30) 37. Cash flow from operation (11+8) 17.00 20.5) (12.00 10.00 4.00 4.5) 1.00 4.27 20. ∆ Inv.5 (12.00 49.5) 50.70 12. Depreciation 9.00 10.

The sales from this product is expected to be as follows: Year 1 Sales (Rs. which of course. At the end of five years. The expected net salvage value after 5 years is Rs.2. The accountant of the firm has provided the following estimates for the cost of Gale. Gale is expected to have a product life cycle of five years after which it will be withdrawn from the market.MINICASE 4 Zesna Auto Ltd is considering the manufacture of a new bike.100 million. The working capital requirement for the project is expected to be 10% of sales.5 million on account of bad debt. Raw material cost : 40 percent of sales Variable manufacturing cost : 20 percent of sales Fixed annual operating and : Rs.5 million maintenance costs Variable selling expenses : 15 percent of sales The tax rate for the firm is 30 percent.600 million and it will be depreciated at the rate of 25 percent per year as per the WDV method for tax purposes. working capital is expected to be liquidated at par. barring an estimated loss of Rs. Gale. in million) 700 • 2 3 850 1100 4 1000 5 800 • • • The capital equipment required for manufacturing Gale costs Rs. for which the following information has been gathered. will be tax-deductible expense. Working capital level will be adjusted at the beginning of the year in relation to the sales for the year. (b) What is the NPV of the project if the cost of capital is 18 percent? . Required: (a) Estimate the post-tax incremental cash flows for the project to manufacture Gale.

670 + 127.Profit before tax 11.18)5 192.5 105 150 22.75 226.70 (70) (670) 155.5 101.45 + 143.Tax 12.5 5 145. Level of working capital 3.1 212.Recovery of Working Capital 15.5 100 75 (600) 165.5 165 84. Variable selling expenses 8.18)4 216.5 6.86 + 137.Solution: Cash flows for the Gale Project Year 1.1 56.5 127. Bad debt loss 10. Variable manufacturing cost 6.71 + 111.3 184.18)3 (15) 150. Depreciation 9.5 112.9 800 320 160 2.4 188.Initial Investment 16.2 20 212.18)2 (1.0 175 .0 43.75 + (1.5 120 47.8 15.Operating cash flow (12+8+9) 17. Capital equipment 2. in million) 4 5 80 1000 400 200 2.1 10 226.2 55.81 = -39.Profit after tax 13.2 + (1.18) = + 0 600 70 1 85 700 280 140 2.7 2 110 850 340 170 2.670 + (1.5 150 63. Raw material cost 5.5 97.7 180.70 (b) NPV = . Revenues 4.3 128.25 3 100 1100 440 220 2. Terminal cash flow (13 + 14) 18.75 (25) 155.61 + 109.4 131.7 (Rs.2 329 329 154. Operating and maintenance cost 7. Net cash flow (15 + 16 + 17 + 18) 150.56 .1 + (1.25 68. Working Capital investment 19.5 29.Net Salvage Value of Capital Equipment 14.

Torrexin.MINICASE 5 Phoenix Pharma is considering the manufacture of a new drug. Working capital level will be adjusted at the beginning of the year in relation to the sales for the year. At the end of five years. of course. for which the following information has been gathered • Torrexin is expected to have a product life cycle of five years after which it will be withdrawn from the market. The expected net salvage value after 5 years is Rs. working capital is expected to be liquidated at par.30 million The working capital requirement for the project is expected to be 20 percent of sales.5 million on account of bad debt which. The sales from this drug are expected to be as follows: Year 1 Sales ( Rs in million) 100 2 150 3 200 4 150 5 100 • • • The capital equipment required for manufacturing Torrexin is 120 million and it will be depreciated at the rate of 25 percent per year as per the WDV method for tax purposes. will be tax-deductible expense The accountant of the firm has provided the following estimates for the cost of Torrexin Raw material cost : 40 percent of sales Variable manufacturing : 10 percent of sales cost Fixed annual operating and : Rs. barring an estimated loss of Rs.8 million maintenance costs Variable selling expenses : 10 percent of sales The tax rate for the firm is 30 percent • Required : (a) Estimate the post-tax incremental cash flows for the project to manufacture Torrexin (b) What is the NPV of the project if the cost of capital is 15 percent? .

Net cash flow (15 + 16 + 17 + 18) 21. Net salvage value of capital equipment 14.4 (b) NPV = .0 1 2 3 4 5 50. Initial investment 16. Capital equipment 2.6 + 25.9 55.15) + (1.15)5 = .5 29.3 12.0 71.7 + 35. Variable mfrg cost 6.5 8.5 38.6 20 150 60 15 8 15 12. Profit after tax 13. Fixed annual operating and maintenance costs 7.140 + 18.5 + (1. Tax 12.5 (10) 40.3 11.140 + (1.7 26.2 (120) 31.1 + (1.6 1.1 + 28. Variable selling expenses 8.0 15.2 30.2 + 71.1 16.5 17.8 27.6 = Rs 11. Terminal cash flow (13+14) 19.4 20 10 43.2 (10) 45. Level of working capital (ending) 3. Raw material cost 5. Revenues 4.5 50.7 39. Recovery of working capital 15.15)4 (140) 21.4 33.6 30 200 80 20 8 20 16. Bad debt loss 9.1 65. ∆ Working capital 18. Operating cash flow (12 + 8 + 9) 17.1 10 55.7 (120) 20 30 100 40 10 8 10 30 2 0.4 40 150 60 15 8 15 22.5 5.5 100 40 10 8 10 5 9. Profit before tax 11.Solution: (a) 0 1.15)3 65.15)2 33.7 (1.9 20.0 million . Depreciation 10.0 + 43.

(a) Estimate the cash flow associated with the replacement project. It is being depreciated annually at a rate of 20 percent the WDV method.400 206.376 660. It is expected to fetch a net salvage value of Rs.301 . Operating cash flow ( i + iii) 528. Initial outlay (Time 0) Cost of new machine Salvage value of old machine Incremental working capital requirement Total net investment (=i – ii + iii) Rs.900.800. Operating cash flow (years 1 through 4) Year 1 2 3 4 i.000 ii.000 200.200.000 486. Incremental depreciation iii. i.720 165.200.000 528.000.000. Post-tax savings in manufacturing costs 528.1.000 528.000.000 608.2.720 693. (b) What is the NPV of the replacement project if the cost of capital is 15 percent? Solution: (a) A.000 800.000 760. 5.301 786. iii iv.000. The depreciation rate applicable to it is 20 percent under the WDV method. Tax shield on incremental dep.MINICASE 6 Malabar Corporation is determining the cash flow for a project involving replacement of an old machine by a new machine.000 B.120 258.000.000. The old machine bought a few years ago has a book value of Rs.000.400 389.000 after four years.000 annually in manufacturing costs (other than depreciation).400 734. ii.The incremental working capital associated with the new machine is Rs. The working capital associated with this machine is Rs. It has a remaining life of four years after which its net salvage value is expected to be Rs.000 and it can be sold to realise a post tax salvage value of Rs.500. The new machine costs Rs.500. The new machine is expected to bring a saving of Rs.000 4.700.800. iv.5. The tax rate applicable to the firm is 34 percent.376 132.

000 D.000 + 786. 2.376 x PVIF (15.000 500. ii.301 x PVIF (15.200.1) + 734.900.2) + 693.C.400 x PVIF (15.4) = .050 .301 (b) NPV of the replacement project = .000 2.720 3 693.720 x PVIF (15. iii.568.860.400 2 734. Terminal cash flow (year 4) i. Salvage value of new machine Salvage value of old machine Recovery of incremental working capital Terminal cash flow ( i – ii + iii) Rs.Rs.000 200. Year NCF Net cash flows associated with the replacement project (in Rs) 0 (4.1.000) 1 786. iv.376 4 2.860.4.900.3) + 2.500.

(b) What is the NPV of the replacement project if the cost of capital is 14 percent? Solution: (a) A.000 2.400.183.000 411.960 1. Initial outlay (Time 0) Cost of new machine Salvage value of old machine Incremental working capital requirement Total net investment (=i – ii + iii) Rs.129 142.3.422 1.000 after five years.273 .273 1.000. The new machine is expected to bring a saving of Rs.000 and it can be sold to realise a post tax salvage value of Rs. 8. It is expected to fetch a net salvage value of Rs.900. The working capital associated with this machine is Rs.000 300.800.The incremental working capital associated with the new machine is Rs.000.000.000.8. (a) Estimate the cash flow associated with the replacement project. Year Operating cash flow (years 1 through 4) 1 2 3 4 5 i.000.960 1.382.120 555.400 235.000 E.200.1.000 1.125.000.813 201. The new machine costs Rs. The depreciation rate applicable to it is 25 percent under the WDV method.000 1.000 1.142.000 843.000 912.MINICASE 7 Sangeeta Enterprises is determining the cash flow for a project involving replacement of an old machine by a new machine.000 840. i.000.000.358 1. iv.000.235.600.000 600.2. Operating cash flow( i +v) 1. Depreciation on old machine iv.600 713.000.000 588.750 288.800 1.200.000 382.1.000 6. Depreciation on new machine iii.Incremental dereciation v.000.000.684 431.2.160.000.358 632.500.422 1.630 183. iii iv.000. The tax rate applicable to the firm is 33 percent. ii. The old machine bought a few years ago has a book value of Rs.000 2. It has a remaining life of five years after which its net salvage value is expected to be Rs. Post-tax savings in manufacturing costs ii.800 1.Tax shield on incremental dep.500. It is being depreciated annually at a rate of 30 percent the WDV method.300.000.000 annually in manufacturing costs (other than depreciation).000 1.

235.000 3.955 6.549 4.382.44.Rs. Salvage value of new machine Salvage value of old machine Recovery of incremental working capital Terminal cash flow ( i – ii + iii) Rs.800 1.339 20. iii.342.960 1.749 8.000)+ 1.398. 3. A machine costs Rs.843 ---------- Present value of the tax savings on account of depreciation = Rs.3)+ 1.5) = .183.422x PVIF (14.400.586 11.000 45. Terminal cash flow (year 5) i.2) + 1.656 26.183.342.300.946 3.800x PVIF (14.504 11.1)+ 1.522 7.000 600.358 4.843 .273x PVIF (14.F.600 34.a.422 1.34 x DC 1 2 3 4 5 60.000 900.250. What is the present value of the tax savings on account of depreciation for a period of 5 years if the tax rate is 34 percent and the discount rate is 16 percent? Solution: Tax shield (savings) on depreciation (in Rs) Depreciation Tax shield Year charge (DC) =0.000) 1. ii.783 8.235. Year Net cash flows associated with the replacement project (in Rs) 0 1 2 3 4 5 NCF (c) (6.400 15.273 NPV of the replacement project (6.240 ---------44.000 and is subject to a depreciation rate of 24 percent under the WDV method.960x PVIF (14.358x PVIF (14. iv.806 PV of tax shield @ 16% p.017 20. 17.500.4) +4.200.400.000 G.382.300.

000 = 0. The cost of capital is 14 percent.028 97.200) x 3.250 35.433 = 500.335 S . Depreciation will be 80.437 13.712 PV of tax shield @ 18% p.652 21.222 25.014 34.000 and is subject to a depreciation rate of 27 percent under the WDV method.5 S – 360.200) PVIFA (14%.125.33) + 80. A machine costs Rs.335 S -161.200) x 3.36 x DC 1 2 3 4 183. 5) = (0.423 66. we get (0.9.680.000 = 80.200) = 145.955. The effective tax rate is 33 percent.5 of sales (S) = 0.000 (0.645.a.433 Equating this with the initial investment. What is the present value of the tax savings on account of depreciation for a period of 4 years if the tax rate is 36 percent and the discount rate is 18 percent? Solution: Tax shield (savings) on depreciation (in Rs) Depreciation Tax shield Year charge (DC) =0. 56.000 = (0.000) (1-0.000 = 0.600 134.5 S – 360.335 S -161.21 S = 915.85 Variable cost Contribution Fixed cost Depreciation Pre-tax profit Cash flow .000.000 per year.365 CHAPTER 13 1. The unit selling price is 70 and the unit variable cost is 35.335 S -161.840 71.5 of sales (S) = 280.365 ---------Present value of the tax savings on account of depreciation = Rs.5 S – 280.335 S -161. Fixed costs other than depreciation will be 280. What is the financial break-even point? Solution: = 0.096 48.000 per year for tax purposes. A project requires an investment of 500.000 – 80.000 = 0. The life of the project is 5 years.262 ---------125.161.200 PV of cash flow = (0.

000 = 0.433 Equating this with the initial investment. The unit selling price is 50 and the unit variable cost is 25.335 S .200) x 3.335 S -161.4S – 183.2.000 per year for tax purposes.000 = 0.200) PVIFA (14%. What is the financial break-even Point? Solution: Variable cost Contribution margin Fixed costs Depreciation Pre-tax profit Cash flow = 50 percent of sales (S) = 50 percent of sales (S) = 250.000) 0.21 S = 915.000 = 0.000 (0.5 S – 280. The life of the project is 6 years. The cost of capital is 14 percent.6444 S – 752313 = 800. The life of the project is 5 years.5S – 250.5 S – 360. A project requires an investment of 500.000 S = 943999.200) x 3.000 per year. The effective tax rate is 20 percent.183.000 Present value of cash flows is (0.955.000 = 85.5S – 335.000) (1-0.4S .000 = (0.335 S -161.200) = 145.111 Equating this with the initial investment of 800. The cost of capital is 12 percent. Fixed costs other than depreciation will be 250.000) = (0.6 3.5 of sales (S) = 0.645. Depreciation will be 80.000 we get 1.000 – 80. The effective tax rate is 33 percent.433 = 500.000 = (0.000 = 0.000 – 85.335 S -161.85 Variable cost Contribution Fixed cost Depreciation Pre-tax profit Cash flow . What is the financial break-even point? Solution: = 0.000 per year for tax purposes. The unit selling price is 70 and the unit variable cost is 35. Depreciation will be 85.161.5 of sales (S) = 280.000) x 4.200 PV of cash flow = (0. Fixed costs other than depreciation will be 280.000.000 = 80. A project requires an investment of 800. 5) = (0. we get (0.5 S – 360.000.8 + 85.33) + 80.335 S -161.000 per year.

Calculate the effect of variations in the values of the underlying variables on NPV.4. b. Fixed costs 5. in million) 250 400 650 Variable cost as a percent 70 60 55 of sales Fixed costs (Rs. in million) 65 60 50 Cost of capital (%) 18 15 12 a. in million Years 1 . The range of values that the underlying variables can take is shown below: Underlying Variable Pessimistic Expected Optimistic Investment 400 500 700 (Rs. Investment 2. Solution: Expected Scenario 1. Your project staff has developed the following cash flow forecast for the factory. Navneet is planning to set up a factory at Aurangabad. Sales Variable costs as a pecentage of sales 3. You are the financial manager of Navneet Limited. Cash Flow Forecast for Navneet’s factory Rs. in million) Sales (Rs.10 Year 0 Investment (500) Sales Variable costs (60% of sales) Fixed costs Depreciation (assumed at 10% of investment per annum) Pre-tax profit Tax ( at a rate assumed at 30 % of pre-tax profit) Profit after tax Cash flow from operations Net cash flow 400 240 60 50 50 15 35 85 85 What is the NPV of the project? Assume that the cost of capital is 15 percent. Calculate the accounting break-even point. Depreciation(assumed at 10% of investment per annum) 500 400 60 240 60 50 Optimistic Scenario 400 650 55 357. Variable costs 4.5 50 40 Pessimistic Scenario 700 250 70 175 65 70 .

75 141.5 133.75 181. and it is also assumed that this method and rate of depreciation are acceptable to the IT (income tax) authorities.5 . It is assumed that only loss on this project can be offset against the taxable profit on other projects of the company.5 60. You are the financial manager of Magnum Corporation. Your project staff has developed the following cash flow forecast for the project.5 133.93 -60 -18 -42 28 -574. Annual cash flow from operations 10. Pre-tax profit 7. The investment is assumed to be depreciated at 10% per annum. It is also assumed that the salvage value of the investment after ten years is zero. Tax( at a rate assumed at 30 % of pre-tax profit) 8.4 = Rs. Net present value 50 15 35 85 -73. in million Years 1 . Cash Flow Forecast for Navneet’s factory Rs.40 202.8 Year 0 Investment (1000) Sales Variable costs (70% of sales) Fixed costs Depreciation (assumed at 10% of investment per annum) Pre-tax profit Tax (at a rate assumed at 33 % of pre-tax profit) Profit after tax Cash flow from operations Net cash flow 800 560 90 100 50 16.5 33.75 626.4 Break even level of sales = 110 / 0. 110 million Contribution margin ratio = 160 / 400 = 0. Profit after tax 9. (b) Accounting break even point (under ‘expected’ scenario) Fixed costs + depreciation = Rs.275 million 5.17 Assumptions: (1) (2) (3) The useful life is assumed to be 10 years under all three scenarios. Magnum is planning to set up a Machine Tools plant at Chennai. and thus the company can claim a tax shield on the loss in the same year.6.

What is the NPV of the project ? Assume that the cost of capital is 14 percent.875 88.5 95 130 -62. in million) 650 Variable cost as a percent 75 of sales Fixed costs (Rs. Annual cash flow from operations 10.5 -380. Tax( at a rate assumed at 33 % of pre-tax profit) 8. Profit after tax 9.22 (2) The useful life is assumed to be 8 years under all three scenarios. (b) Calculate the accounting break-even point.71 800 1000 60 600 80 80 240 79. and it is also assumed that this method and rate of depreciation are acceptable to the IT (income tax) authorities.8 240. Fixed costs 5. Solution: Expected Optimistic Pessimistic Scenario Scenario Scenario 1. Net present value Assumptions: (1) 1000 800 70 560 90 100 50 16. The range of values that the underlying variables can take is shown below: Underlying Variable Pessimistic Investment 1300 (Rs. in million) 95 Cost of capital (%) 16 Expected 1000 Optimistic 800 800 70 90 14 1000 60 80 13 (a) Calculate the effect of variations in the values of the underlying variables on NPV. Investment 2. in million) Sales (Rs. Depreciation(assumed at 10% of investment per annum) 6.2 160.54 1300 650 75 487. It is also assumed that the salvage value of the investment after eight years is zero. .5 33.8 355. Sales Variable costs as a percentage of sales 3. Variable costs 4. The investment is assumed to be depreciated at 10% per annum.625 -41.125 -917.5 133. Pre-tax profit 7.5 -20.

and thus the company can claim a tax shield on the loss in the same year. Calculate the sensitivity of net present value to variations in (a) quantity manufactured and sold. and (c) variable cost per unit.000 Rs.35 Rs.35 Optimistic 3. = Rs.60 Rs.50. (b) price per unit.3 = Rs.800 Price per unit Rs. .633.000 Tax rate 35% Life of the project 6 years Net salvage value Nil Assume that the following underlying variables can take the values as shown below: Underlying variable Quantity manufactured and sold Price per unit Variable cost per unit Pessimistic 2.000 Depreciation Rs.20 a.000 Cost of capital 12% Quantity manufactured and sold annually 2. with their respective expected values. have a bearing on the NPV of this project.(3) It is assumed that only loss on this project can be offset against the taxable profit on other projects of the company. (b) Accounting break even point (under ‘expected’ scenario) Fixed costs + depreciation Contribution margin ratio Break even level of sales 6.5. Initial investment Rs.33 million Rakesh Limited is considering the risk characteristics of a certain project.8.50 Variable cost per unit Rs.500 Rs. 190 million = 0.3 = 190 / 0. The firm has identified that the following factors.28 Fixed costs Rs.

810 31.000 50.000 98.000 56.600 17.264 .400 8.010 2.400 8.400 41.000 140.436 -11.000 8.000 8.000 22.000 100.290 49.400 78.600 141.590 4.000 8.400 78.Solution: Sensitivity of net present value to quantity manufactured and sold Expected Pessimistic Optimistic Quantity manufactured and sold annually Initial investment Sales revenue Variable costs Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow 2.000 31.600 46.402 3500 50.290 54.590 9.000 50.000 78.800 50.000 168.436 2000 50.805 175.790 100.010 31.000 64.600 6.850 20.590 36.592 NPV at a cost of capital of 12 % and useful life of 6 years Sensitivity of net present value to price per unit Price per unit Initial investment Sales revenue Variable costs Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow NPV at a cost of capital of 12 % and useful life of 6 years Expected Pessimistic Optimistic 50 35 60 50.000 48.590 100.600 17.310 26.000 175.790 36.000 5.000 98.000 10.000 5.600 76.000 5.000 48.000 5.150 25.000 78.150 53.000 8.000 5.000 140.000 5.

Cash Flow (Rs. in mln) 0.590 18. Calculate the expected net present value and the standard deviation of net present value assuming that i = 12 percent.3 6 0.150 36.3 + 9 x 0. Year 1 Cash Flow (Rs.2 10 Year 3 Prob.5 + 8 x 0. Expected Pessimistic Optimistic 28 35 20 50.600 29.2 7 0.9 6 x 0.000 56.000 140.000 140.5 + 9 x 0.000 5.436 48.12 +7.6 5 x 0.5 5 0.000 50.3 0.850 46.000 8.2 7.298 Variable cost per unit Initial investment Sales revenue Variable costs Fixed costs Depreciation Profit before tax Tax Profit after tax Net cash flow NPV at a cost of capital of 12 % and useful life of 6 years 7.850 51. A project involving an outlay of Rs.590 23.000 50.15 million has the following benefits associated with it.3 7.850 31.400 98.3 9 Prob.150 100.12)3 – 15 Rs.Sensitivity of net present value to variable cost per unit. Solution: Define At as the random variable denoting net cash flow in year t.000 71.8 / (1. in mln) 0. A1 A2 = = = = = = = = 7 x 0.6 / (1. Cash Flow (Rs.000 17.4 + 7 x 0.4 0.150 24.000 5.000 5.010 10. 0. in mln) 7 8 9 Year 2 Prob.057 160.5 8 0.000 8.3 Assume that the cash flows are independent.3 + 8 x 0.8 7.000 8.2 + 10 x 0.9 / 1.95 million A3 NPV .3 6.000 140.000 78.000 48.2.12)2 + 6.

8)2+0.3= 11.5(12-11.76/(1.15)3 – 25 = Rs.2(11-10)2+0.9)2 + 0.5 11 0.3(9-6. A project involving an outlay of Rs.9 9 x 0.4(13-12.6)2+0.1.9)2 = 1.12)6 = 3.1= 12.93 million 8.2 + 12 x 0.6)2+0.1 Assume that the cash flows are independent.6)2+0.1.2(8-7.04 = 0.3x( 7-7.9)2 = 0.9)2 + 0.5 0.6 / (1. in mln) 0. in mln) 0.3 12 Year 3 Prob.1(14-12.6)2+0.2 14 Prob.9)2 + 0.12) 2 + (1.49 = 0.8)2 = 2.15 +10 / (1.2(9-7.2x( 10-11.49/(1.9 / 1. Year 1 Cash Flow (Rs.5(12-12.76 σ12 σ22 σ32 σ2 NPV = + (1.5(6-7.3(10-7.3(7-6.12)6 = 0.5 + 13 x 0.6(9-10)2+0. Calculate the expected net present value and the standard deviation of net present value assuming that i = 15 percent.3(13-11.2 + 12 x 0.04/(1.2 13 0.5 + 13 x 0. A1 A2 A3 = = = = 10 x 0. Cash Flow (Rs.2 9 0. Solution: Define At as the random variable denoting net cash flow in year t.6)2 = 0.5(8-7.12)6 .12) (1.6 12 0.6)2 = 3.6 = 0.12) 4 (1.6 + 11 x 0. in mln) 10 12 13 Year 2 Prob.σ12 σ22 σ32 = 0.15)2 + 12.4 0.19 million NPV σ12 σ22 σ32 = 0.12) (1. Cash Flow (Rs.12)2 + 3.12)4 + 2.2 = 10 12 x 0.09 = 0.2(12-10)2 = 1.4(5-6.25 million has the following benefits associated with it.72 σ (NPV) = Rs.9)2 + 0.44 σ12 σ22 σ32 σ2 NPV = + + 2 4 (1.8)2+0. 0.4 + 14 x 0.6 11.

000 / (1.1. Mohan is considering an investment which requires a current outlay of Rs.3.000 20.44/(1.15)4 + 0.000 4.000 7.000 / (1.000 4.07)4 11.15)2 + 1.6/(1.15)6 = 1.07)2 + 4.93 σ (NPV) = Rs.088. if the risk-free interest rate is 10 percent.000 10. Calculate the expected net present value and standard deviation of net present value of this investment.000 The cash flows are perfectly correlated.000 / (1.07)t = 25.000.25.07)3 + 2.000 = 30.07)3 + 10.07) + 4.000.523 Standard deviation of NPV σt 4 ∑ t=1 (1.000 Standard Deviation Rs. if the risk-free interest rate is 7 percent.40.39million 9.000/(1.000 / (1.000 14. .07)2 + 14.25. Solution: Expected NPV 4 At = ∑ .000 The cash flows are perfectly correlated.48 Boldman is considering an investment which requires a current outlay of Rs.8.000 / (1.000 15.000 34. The expected value and standard deviation of cash flows are: Year 1 2 3 4 Expected Value Rs. The expected value and standard deviation of cash flows are: Year 1 2 3 4 Expected Value Rs.000 / (1. Calculate the expected net present value and standard deviation of net present value of this investment.000 9. 3.000 2.000 10.100.= 1.000 / (1.07)t = = 10.25.07) + 15.000 t=1 (1.000 Standard Deviation Rs.07)4 – 25.000 55.09/(1.

000 x 0.Solution: Expected NPV 4 At = ∑ .3 120.2 = 118.1 ? Expected NPV 4 At = ∑ .1)2 + 7.1)t = 40.2 0.1)4 26.3 + 150.000 120.5 0. (a) (b) (c) Solution: (a) What is the expected NPV ? If the NPV is approximately normally distributed.000 0.000 x 0. Year 4 Cash Flow Prob.3 0. Year 1 Cash Flow Prob.1)t = = 11.000 x 0.4 0.000 x 0.1) + 55.000 130.000 130.1) + 10.000 x 0.000 .4 + 120.1)4 – 100.000 x 0.000 = 21.08)t A1 = 110.4 + 130.000 120.000/(1.000 140.3 0.000 x 0.000 140.000 / (1.944 Dinesh Associates is considering an investment project which has an estimated life of four years.5 = 143.2 = 127.2 130.023 Standard deviation of NPV σt 4 ∑ t=1 (1.000 / (1.000 x 0.3 = 120. what is the probability that the NPV will be zero or less ? What is the probability that the profitability index will be greater than 1.5 + 130.000 ….000 x 0. 8. 110.3 + 140.2 The cash flows of various years are independent and the risk-free discount rate (post-tax) is 8 percent.4 0.000 x 0.000 t=1 (1.000 0.3 0.1)3 + 9.100.000 0.3 + 120. Year 3 Cash Flow Prob.000 x 0.400. (1) t=1 (1.000 150.000 A3 = 130.000 x 0.000 / (1.4 + 130.4 0.000 / (1.1)3 + 20.000 / (1.000 130.000 / (1.000 / (1.5 110.000 A2 = 120.000 0.000 A4 = 110.2 + 140. The cost of project is 400.000 and the possible cash flows are given below: Year 2 Cash Flow Prob.1)2 + 34.

0606 – 0.60.0606 Extrapolating.000 –127.844 NPV – NPV 0 .000.400.2]= 56.000)2 x 0.000/ (1.000 –120.000/ (1. σ NPV 0 – 20.000 / (1.08)2t σ12= [(110.NPV Prob (NPV < 0) = Prob.3] = 60.000 –118.000 / (1.000/ (1.08)3 + 118.000)2 x 0.08)4 + 61.3+(120.000)2 x 0.58) From the normal distribution tables.58)(0.5] = 61. we have.555 σ NPV = 164.4 + (120.55.000 –118. we get Prob (Z < . (2) t=1 (1.5 + (130.000)2 x0.60-1.000–120.972.4 + (130.000 –143.000)2 x 0.3 + (140.972.000)2 x 0.0548 + 0.000 –127.555= Rs.58) = 0.000)2 x 0.000 2 σ2 = [(120.000.000 Substituting these values in (2) we get σ2 (NPV) =60.Substituting these values in (1) we get Expected NPV = NPV =120.000 2 σ4 = [(110.2]= 61.000)2 x 0.000)2 x 0.2 + (140.000)2x0.12.000/ (1.000 / (1..000)2 x 0.000 2 σ3 = [(130.245 (b) The variance of NPV is given by the expression 4 σ2t σ2 (NPV) = ∑ …….71 % (c) Prob (P1 > 1.000 –143.0548 +(1.000. when Z = -1.08)8 = 164.4 = +(130.000 –143.000.1. the probability =0.000 / (1.08)+ 127.000.08)2 + 143.05 = 0.0548)/0.000–120.0548 when Z = -1.000 –127.000 –118.000.000 = 20.844 < σ NPV = Prob (Z < .3 + (150.0571 So the probability of NPV being negative is 5.245 = Prob Z < 12.1.000.08)2 + 61.000)2 x 0. the probability = 0.08)4 .1) Prob (PV / I > 1.08)6 + 56.000.1) Prob (NPV / I > 0.00232 = 0.1) .

08t Calculate the net present value of the project if the risk-free rate of return is 8 percent Solution: Certainty Equivalent Factor: αt =1 . we have.9332 + 0.50)(0. (NPV > 0.000) Prob (NPV > 40.0668 = 0.76 0.54) = 0.000 3 20.000 5 10 .54-1.680583 NPV = -50000 8519 21605 12066 9996 4083 6270 . the probability = 1 – 0.1.793832 0.844) = Prob (Z > .1 x 400.000 2 30.50.000) Prob (NPV > 40.245 )/ 12.Prob.0.000 4 20.9382 So the probability of P1 > 1.82% 12.05 = 0.84 0. we get Prob (Z > .92 0. the probability = 1 – 0.0606 =0.000)= Prob (Z > (40.20.000) 1 10.55.857339 0.73503 0.000. (50.1 is 93.9394 when Z = 1. The expected cash flows of a project are given below: Year Cash Flow 0 Rs. when Z =1.9332 Extrapolating.925926 0.08t Certainty Equivalent value Discount Factor at 8% Year Cash Flow Present Value 0 1 2 3 4 5 -50000 10000 30000 20000 20000 10000 1 0.000 The certainty equivalent factor behaves as per the following equation : αt = 1 – 0.6 -50000 9200 25200 15200 13600 6000 1 0.54) From the normal distribution tables.9394 – 0.1.9332)/0.00496 = 0.9332 +(1.68 0.

and 35 percent debt.4 x 100) + (0.102 per share.6 x 103) 101.x 11 = 8. ARN’s debentures consist of Rs.x 6. 5 percent preference.8 Pre-tax cost of working capital loan = 11% 2600 2500 Average pre-tax cost of debt = -------.100 par.= -------. ARN’s preference capital has a post-tax cost of 7 percent.00 per share and the dividend per share is expected to grow at a rate of 14 percent per year in future. ARN’s equity stock is currently selling for Rs. the risk-free rate is 6 percent. and the market risk premium is 8 percent. with a residual maturity of 3 years.3. 8 percent coupon payable annually.5.88 + -------. ARN’s equity beta is 1.CHAPTER 14 1 The latest balance sheet of ARN Limited is given below Liabilities Assets Equity capital Preference capital Reserves & Surplus Debentures Working capital loan Current liabilities & Provisions 3500 Fixed assets 200 Investments 5200 Current assets. ARN’s tax rate is 33 percent (i) What is ARN’s average pre-tax cost of debt? (Use the approximate yield formula) Solution: 8 + (100-103) / 3 7 Pre-tax cost of debenture = ---------------------------. Working capital loan carries an interest rate of 11 percent. The market price of these debentures is Rs.88% (ii) What is ARN’s cost of equity using the constant growth dividend discount model? Solution: . Its last dividend was Rs.103. loans & advances 2600 2500 1500 15500 11000 800 3700 15500 The target capital structure of ARN has 60 percent equity.= (0.90 % 5100 5100 6.

90 (1-0.00 per share and the dividend per share is expected to grow at a rate of 12 percent per year in future. 9 percent coupon payable annually. Working capital loan carries an interest rate of 10 percent. and 30 percent debt.35 x 8.+ 0. The latest balance sheet of MM Limited is given below Liabilities Assets Equity capital Preference capital Reserves & Surplus Debentures Working capital loan Current liabilities & Provisions 3200 300 6800 2100 2000 1700 16100 Fixed 10500 Investments 1100 Current assets. MM’s debentures consist of Rs. with a residual maturity of 4 years.35 % 102 P0 (iii) What is ARN’s post tax weighted average cost of capital? Use the CAPM to estimate the cost of equity and employ the weights in the target capital structure.14 = 17. the risk-free rate is 7 percent.100 par. MM’s equity beta is 1.5 x 8 = 18% rA = 0.2.90 per share. MM’s preference capital has a post-tax cost of 8 percent.105.33) = 13.24% 2. The market price of these debentures is Rs.05 x 7 + 0.05.60 x 18 + 0. MM’s equity stock is currently selling for Rs. 4500 assets loans & advances 16100 The target capital structure of MM has 65 percent equity. 5 percent preference. Solution: rE = 6 + 1. MM’s tax rate is 30 percent (i) What is MM’s average pre-tax cost of debt? (Use the approximate yield formula) Solution: . and the market risk premium is 6 percent.+ g = ------.42 D0 ( 1+g) rE = ------------.3. Its last dividend was Rs.

Pre-tax cost of debenture 9 + (100 – 105) / 4 0.52% (ii) What is MM’s cost of equity using the constant growth dividend discount model ? Solution: rE = = D0 (1+g) P0 14.05 x 8 0.6 x 105 + 0.4 + + 0.619 .73 % + 10% 4100 2000 = 7.30% 0.85 + 4.73 2.4 x 100 Pre-tax cost of working capital loan = 10% Average pre-tax cost of debt 2100 7.52% 4100 = 3.3 x 8.12) 90 + 0.65 x 13.3 8.664 = + + 13.49 % +g = 2 (1.05 (6) 0. Solution: rE rA = = = = 7 + 1.645 11.88 = 8.12 (iii) What is MM’s post tax weighted average cost of capital? Use the CAPM to estimate the cost of equity and employ the weights in the target capital structure.

5 percent preference.100 par. Phoenix’s equity beta is 0.6 x 105 + 0.12 ) + 0. loans & advances 4000 1000 1500 6500 The target capital structure of Phoenix has 70 percent equity. The market price of these debentures is Rs.125 per share. Phoenix’s equity stock is currently selling at Rs. Phoenix’s tax rate is 30 percent (i) What is Phoenix’s pre-tax cost of debt? (Use the approximate yield formula) Solution: 8 + (100 – 105) / 5 = 6.3.105.80% 0. and the market risk premium is 7 percent. Phoenix’s preference capital has a post-tax cost of 9 percent. and 25 percent debt.9. 8 percent coupon payable annually. Its last dividend was Rs. The latest balance sheet of Phoenix Limited is given below Liabilities Assets Equity capital Preference capital Reserves & Surplus Debentures Current liabilities & Provisions 1500 200 2000 1800 1000 6500 Fixed assets Investments Current assets.4 x 100 (ii) What is Phoenix’ cost of equity using the constant growth dividend discount model? Solution: D0 (1 + g ) rE = P0 + g = 3 ( 1. Phoenix’s debentures consist of Rs.12 = 14. the risk-free rate is 7 percent.3. with a residual maturity of 5 years.69% 125 (iii) What is Phoenix’s post tax weighted average cost of capital? Use the CAPM to estimate the cost of equity and employ the weights in the target capital structure. Solution: .00 per share and the dividend per share is expected to grow at a rate of 12 percent per year in future.

80 ( 1 .05 x 9 + 0. The book value per share is Rs.rA 4.60 and the market price per share is Rs.31 + 0.36 6. North Star Limited has 30 million equity shares outstanding. Astute’s pre-tax cost of debt is 10 percent and its debt-equity ratio is 1. What are North Star’s capital structure weights on a book value basis and on a market value basis? Solution: The book value and market values of the different sources of finance are provided in the following table.5/2.180. North Star also has a bank loan of Rs. Nishant’s pre-tax cost of debt is 12 percent and its debt-equity ratio is 2:1. It will mature in 7 years. The second issue has a face value of Rs.5) x 10% x (1 – 0. Astute Corporation’s WACC is 11 percent and its tax rate is 36 percent. What is the beta of Astute’s equity? Solution: Given: (1.5) x r = 11 % where r is the cost of equity capital. and sells for 108 percent of its face value.45 + 1.3 + 0.33) + 1/3 x r = 14% where r is the cost of equity capital.3% = 0. What is the beta of Nishant’s equity? Solution: Given: 2/3 x 12% x (1 – 0.0.300 million.9 ( 7 ) = 13. Therefore r= (14-5.95 % Nishant Limited’s WACC is 14 percent and its tax rate is 33 percent. 13 percent coupon. rE = 7 + 0.9% Solving this equation we get β = 1.5 = 17.84) x 2.9 % Using the SML equation we get: 7% + 8% x β = 17. . The first issue has a face value of Rs.5:1.92 % Solving this equation we get β = 2.70 x 13.3 ) = 9. The book value weights and the market value weights are provided within parenthesis in the table.99 5. and sells for 95 percent of its face value. 12 percent coupon.25 x 6.36)x 3 = 25.19 = 10.92 % Using the SML equation we get: 8% + 6% x β = 25. It will mature in 6 years.400 million. Therefore r= (11-3. The risk-free rate is 7 percent and the market risk premium is 8 percent. The risk-free rate is 8 percent and the market risk premium is 6 percent. North Star has two debenture issues outstanding.36) + (1/2.300 million on which the interest rate is 14 percent.

in million) Source Equity Debentures Bank loan Total Book value 10.00) 8. a.98) 680(0. Jaihind has a debenture issue outstanding with a face value of Rs. Jaihind also has a bank loan of Rs.4125 = 11.600 million on which the interest rate is 11 percent. If Friends Associate’s cost of equity is 22 percent. and it sells for 85 percent of its face value.680. It will mature in 4 years. Jaihind Corporation has 100 million equity shares outstanding.11) Bank loan 300 (0.000 (0. (Rs.(Rs. What are Jaihind’s capital structure weights on a book value basis and on a market value basis? Solution: The book value and market values of the different sources of finance are provided in the following table. The book value per share is Rs.07) 600 (0.400 (1. Friends Associates manufactures industrial solvents.00) Market value 5400 (0.280 (1.64) Debentures – first series 400 (0.34) x (5/8) + 22% x (3/8) = 13 % rD = (13 -8.01) 69.5% where rD represents the pre-tax cost of debt.06) 324 (0.00) Market value 68. If Friends Associates can issue debt at an interest rate of 10 percent. Its debt-equity ratio is 5:3 Its WACC is 13 percent and its tax rate is 34 percent.800 million.11) Total 2800 (1. what is its cost of equity? Solution: (a) Given: rD x (1 – 0.25)/0.01) 600 (0.14) Debentures – second series 300 (0. what is its pre-tax cost of debt? b.05) 300 (0.100 and the market price per share is Rs.000 (0. The coupon rate for a debenture is 13 percent coupon.84) 380 (0.05) 6404 (1. in million) Source Book value Equity 1800 (0. . The book value weights and the market value weights are provided within parenthesis in the table.00) 7.05) 11.88) 800 (0.

38 % = 18.1million of debt costing 14(1-. The next dividend expected is Rs.76 % The marginal cost of capital in the second chunk will be : 3/4 x 21% + 1/4 x 9.04 per cent The second chunk of financing will comprise of Rs. The interest rate applicable to additional debt would be as follows: First Rs.1 % Note : We have assumed that (i) The net realisation per share will be Rs. Additional equity can be issued at Rs.90 million The company plans to maintain this market-value capital structure. The company has a plan to invest Rs.06 = 21 % (a) The first chunk of financing will comprise of Rs.3 million of debt costing 12 (1-.6 million of retained earnings and 3 millions of fresh equity costing 21 percent and Rs.00 / 40 + 0.33) = 8.3 million Next Rs.30 million Equity Rs.1 million Required: (a) At what amounts of new capital will there be breaks in the marginal cost of capital schedule? (b) What will be the marginal cost of capital in the interval between each of the breaks? Solution: 12 percent 14 percent The tax rate for the firm is 33 percent.33) = 9.16 million next year.9. The expected rate of dividend growth is 6 percent.04 % = 17. Cost of equity = D1/P0 + g = 6.3 million of additional equity costing 21 per cent and Rs.35.6 million Rs. and (ii) The planned investment of Rs.16 million is inclusive of floatation costs . after floatation costs. Pioneer Limited’s capital structure in terms of market value is: Debt Rs.40 per share.4 million The company’s equity stock presently sells for Rs.35 per share (net).6 million Rs. This will be financed as follows: Retained earnings Additional equity Debt Rs.00.6.38 per cent The marginal cost of capital in the first chunk will be : 9/12 x 21% + 3/12 x 8.

00 / 20 + 0.10 30 % (b) The first chunk of financing will comprise of Rs. Mahaveer Cotspin’s capital structure in terms of market value is: Debt Equity Rs.7 % The marginal cost of capital in the second chunk will be : 6/10 x 30% + 4/10 x 9.6 million The company’s equity stock presently sells for Rs.90 per cent The marginal cost of capital in the first chunk will be : 6/10 x 30% + 4/10 x 9. The interest rate applicable to additional debt would be as follows: First Rs.90 % = 21.4 million of debt costing 14 (1-.24 per cent The second chunk of financing will comprise of Rs.15 million is inclusive of floatation costs .4.96 % Note : We have assumed that (i) The net realisation per share will be Rs.10.5 millions of fresh equity costing 30 percent and Rs.4.2million of debt costing 15(1-. This will be financed as follows: Retained earnings Additional equity Debt Rs.5 million Rs.50 million Rs. Additional equity can be issued at Rs. The expected rate of dividend growth is 10 percent. The next dividend expected is Rs.18.00.3 million of additional equity costing 30 per cent and Rs.34) = 9.20 per share.4.5 million of retained earnings and 1.18 per share (net).4 million Next Rs.5 million Rs. after floatation costs.75 million The company plans to maintain this market-value capital structure. and (ii) The planned investment of Rs.4.34) = 9.2 million Required: (a) (b) Solution: 14 percent 15 percent The tax rate for the firm is 34 percent. The company has a plan to invest Rs.24 % = 21.15 million next year. At what amounts of new capital will there be breaks in the marginal cost of capital schedule? What will be the marginal cost of capital in the interval between each of the breaks? Cost of equity = = = D1/P0 + g 4.

the additional issue of equity stock will fetch a net price per share of Rs.62 % .10 = 11.10 par) Preference capital. 80 million Rs.200 million Rs.97 % The pre-tax cost of debentures.4 x 100 = 11.40 million.000. (a) Calculate the average cost of capital using (i) book value proportions. are selling for Rs.3. 14 percent Rs. Rs. Modern Limited has the following book value capital structure: Equity capital (25 million shares. using the approximate formula.00. using the approximate formula. Debentures.4x100 = 12.6 x 90 + 0.6x105 + 0. The market price per share is Rs.260. is currently selling for Rs. redeemable after 8 years.000 debentures.100 par) Retained earnings Debentures 14 percent (2.280 million next year.100 million and 13 percent for the next Rs.40 million earnings next year.0 / 260 + 0. and (ii) market value proportions (b) Define the marginal cost of capital schedule for the firm if it raises Rs. Rs. Rs. redeemable after 5 years. 220 million Rs. the debt capital raised by way of term loans will cost 12 percent for the first Rs. The dividend per share is expected to grow at the rate of 10 percent.105 per debenture. is: 10 + (100-90)/8 rP = 0.11.15 % The cost of preference capital.000 shares.90 per share. 10 percent (800. Preference stock.250 million Rs.800 million The next expected dividend per share is Rs. is : 14 + (100-105)/5 rD = 0. 50 million Rs. given the following information: (i) (ii) (iii) (iv) the amount will be raised from equity and term loans in equal proportions the firm expects to retain Rs. The tax rate for the company is 34 percent.100 par) Term loans.250. Solution: (a) (i) The cost of equity and retained earnings rE = D1/PO + g = 3.

The post-tax cost of debentures is 12.62 (1-tax rate) = 12.62 (1 – 0.34) = 8.33% The post-tax cost of term loans is 14 (1-tax rate) = 14 (1 – 0.34) = 9.24 % The average cost of capital using book value proportions is calculated below :
Source of capital Component Cost (1) 11.15% 11.97% 11.15% 8.33 % 9.24 % Book value Rs. in million (2) 250 80 50 200 220 Book value proportion (3) 0.31 0.10 0.06 0.25 0.28 Product of (1) & (3)

Equity capital Preference capital Retained earnings Debentures Term loans

3.46 1.20 0.67 2.08 2.59 10.0 %

800

Average cost of capital

(ii)

The average cost of capital using market value proportions is calculated below:
Source of capital Component cost (1) Market value Market value Product of proportion Rs. in million (2) (3) (1) & (3)

Equity capital and retained earnings Preference capital Debentures Term loans

11.15% 11.97% 8.33% 9.24%

6,500 72 210 220 7,002

0.93 0.01 0.03 0.03 Average cost of capital

10.37 0.12 0.25 0.28 11.02 %

(b) The Rs.280 million to be raised will consist of the following: Retained earnings Rs.40 million Additional equity Rs. 100 million Debt Rs. 140 million The first batch will consist of Rs. 40 million each of retained earnings and debt costing 11.15 percent and 12(1-0.34)= 7.92 percent respectively. The second batch will consist of Rs. 60 million each of additional equity and debt at 11.15 percent and 7.92 percent respectively. The third chunk will consist of Rs.40 million each of additional equity and debt costing 11.15 percent and 13(1-0.34) = 8.58 percent respectively. The marginal cost of capital in the chunks will be as under First batch : (0.5x11.15 ) + (0.5 x 7.92) Second batch : (0.5x11.15 ) + (0.5 x 7.92) Third batch : (0.5x11.15 ) + (0.5 x 8.58) = = = 9.54 % 9.54 % 9.87%

The marginal cost of capital schedule for the firm will be as under. Range of total financing (Rs. in million) 0 - 200 201-280 Weighted marginal cost of capital (%) 9.54 9.87

Here it is assumed that the Rs.280 million to be raised is inclusive of floatation costs. 12. Madhu Corporation has the following book value capital structure: Equity capital (30 million shares, Rs.10 par) Preference capital, 15 percent (1,000,000 shares, Rs.100 par) Retained earnings Debentures 11 percent (2,500,000 debentures, Rs.100 par) Term loans, 13 percent Rs.300 million Rs. 100 million Rs. 100 million Rs .250 million Rs. 300 million Rs.1050 million The next expected dividend per share is Rs.4.00. The dividend per share is expected to grow at the rate of 15 percent. The market price per share is Rs.80. Preference stock, redeemable after 6 years, is currently selling for Rs.110 per share. Debentures, redeemable after 6 years, are selling for Rs.102 per debenture. The tax rate for the company is 35 percent. (a) Calculate the average cost of capital using (i) book value proportions, and (ii) market value proportions

(b) Define the marginal cost of capital schedule for the firm if it raises Rs.450 million next year, given the following information: (i) the amount will be raised from equity and term loans in the proportion 2:1. (ii) the firm expects to retain Rs.80 million earnings next year; (iii) the additional issue of equity stock will fetch a net price per share of Rs.75. (iv) the debt capital raised by way of term loans will cost 11percent for the first (v) Rs.100 million and 12 percent for amounts thereafter.
Solution:

(a) (i) The cost of equity and retained earnings
rE

= D1/PO + g = 4.0 / 80 + 0.15 = 20 % 15 + (100-110)/6

The cost of preference capital, using the approximate formula, is :
rP

= 0.6 x 110 + 0.4 x 100

= 12.58 %

The pre-tax cost of debentures, using the approximate formula, is : 11 + (100-102)/6
rD

= 0.6x102 + 0.4x100

= 10.54 %

The post-tax cost of debentures is 10.54 (1-tax rate) = 10.54 (1 – 0.35) = 6.85 % The post-tax cost of term loans is 13 (1-tax rate) = 13 (1 – 0.35) = 8.45 %

The average cost of capital using book value proportions is calculated below:
Source of capital Component Cost (1) Book value Book value Rs. in million proportion (2) (3) Product of (1) & (3)

Equity capital Preference capital Retained earnings Debentures Term loans

20.00% 12.58 % 20.00% 6.85 % 8.45%

300 100 100 250 300 1050

0.29 0.09 0.09 0.24 0.29

5.8 1.13 1.80 1.64 2.45

Average cost 12.82 % of capital

(ii) The average cost of capital using market value proportions is calculated below :

Source of capital

Component cost (1)

Market value Market value Product of proportion Rs. in million (2) (3) (1) & (3)

Equity capital and retained earnings Preference capital Debentures Term loans

20.00% 12.58% 6.85% 8.45%

2400 110 255 300 3065

0.78 0.04 0.08 0.10 Average cost of capital

15.60 0. 50 0. 55 0. 85 17.50 %

(b)

The Rs.450 million to be raised will consist of the following: Retained earnings Rs.80 million Additional equity Rs. 220 million Debt Rs. 150 million The first batch will consist of Rs. 80 million of retained earnings and Rs.40 million of debt costing 20 percent and 11(1-0.35) = 7.15 percent respectively. The second batch will consist of Rs. 120 million of additional equity and Rs. 60 million of debt at 20 percent 7.15 percent respectively. The third chunk will consist of Rs.100 million of additional equity and Rs.50 million of debt costing 20 percent and 12(1-0.35) = 7.8 percent respectively.

The marginal cost of capital in the chunks will be as under First batch : (2/3)x20 + (1/3) x 7.15 = 15.72 % Second batch : (2/3)x20 + (1/3) x 7.15 = 15.72 % Third batch : (2/3)x 20 + (1/3) x7.8 = 15.93% The marginal cost of capital schedule for the firm will be as under. Range of total financing (Rs. in million) 0 - 300 301-450 Weighted marginal cost of capital (%) 15.72 15.93

Here it is assumed that the Rs.450 million to be raised is inclusive of floatation costs. 13. Imperial Industries is currently at its target debt-equity ratio of 0.8 : 1. It is considering a proposal to expand capacity which is expected to cost Rs.600 million and generate after-tax cash flows of Rs.150 million per year for the next 10 years. The tax rate for the firm is 35 percent. Ganesh, the CFO of the company, has considered two financing options : (i) Issue of equity stock. The required return on the company’s new equity is 25 percent and the issuance cost will be 10 percent. (ii) Issue of debentures at a yield of 14 percent. The issuance cost will be 2 percent. a. What is the WACC for Imperial Industries? b. What is Imperial Industries’s weighted average floatation cost? c. What is the NPV of the proposal after taking into account the floatation costs?
Solution:

(a)

WACC

= =

4/9 x 14% x (1 – 0.35) + 5/9 x 25% 17.93%

(b)

Weighted average floatation cost = 4/9 x 2% + 5/9 x 10% = 6.44 %

(c)

NPV of the proposal after taking into account the floatation costs = = 150 x PVIFA (17.93%, 10) – 600 / (1 - 0.0644) 675.79 – 641.30 = Rs. 34.49million

14.

Pan India Limited is currently at its target debt-equity ratio of 1.5 : 1. It is considering a proposal to expand capacity which is expected to cost Rs.1000 million and generate after-tax cash flows of Rs.200 million per year for the next 12 years. The tax rate for the firm is 33 percent. Ravikiran, the CFO of the company, has considered two financing options : (i) Issue of equity stock. The required return on the company’s new equity is 19 percent and the issuance cost will be 11 percent. (ii) Issue of debentures at a yield of 12 percent. The issuance cost will be 1.5 percent. a. What is the WACC for Pan India? b. What is Pan India’s weighted average floatation cost? c. What is the NPV of the proposal after taking into account the floatation costs?

Solution:

(a)

WACC

= =

(3/5) x 12% x (1 – 0.33) + (2/5) x 19% 12.42%

(b)

Weighted average floatation cost = 3/5 x 1.5 % + 2/5 x 11% = 5.3 %

(c)

NPV of the proposal after taking into account the floatation costs = = 200 x PVIFA (12.42%, 12) – 1000 / (1 - 0.0533) 1215.13 – 1056.30= Rs. 158.83million

15.

Jawahar Associates, an all-equity firm, is evaluating the following projects:
Project Beta ExpectedReturn (%) 12 14 18 24

A B C D

0.4 0.8 1.3 1.8

The risk-fee rate is 8 percent and the expected market premium is 7 percent. Jawahar’s cost of capital is 16 percent. Which projects would be accepted or rejected incorrectly on the basis of the firm’s cost of capital as a hurdle rate?

Projects 2.6 17.2 1.7 14 16 18 25 Given a hurdle rate of 15% (the firm’s cost of capital). Projects C and D would be accepted because the expected returns on these projects exceed 16%. Aryan Limited. Based on this comparison. project 1 would have been rejected because the expected returns on this project is below 15%. Beta ExpectedReturn (%) 14 16 18 25 1 2 3 4 0.3 Expected return (%) 1 2 3 4 0. Aryan’s cost of capital is 15 percent.2 1.8 13.1 1. an all-equity firm. we find that all the four projects need to be rejected. An appropriate basis for accepting or rejecting the projects would be to compare the expected rate of return and the required rate of return for each project.1 16.Solution: Project Beta Required return based on SML equation (%) Expected return (%) A B C D 0.4 0. projects A and B would have been rejected because the expected returns on these projects are below 16%.8 10.7 The risk-fee rate is 7 percent and the expected market premium is 9 percent.9 1. Which projects would be accepted or rejected incorrectly on the basis of the firm’s cost of capital as a hurdle rate? Solution: Project Beta Required return based on SML equation (%) 15.9 17. is evaluating the following projects: Project No.8 22.1 20. 16.6 12 14 18 24 Given a hurdle rate of 16% (the firm’s cost of capital). 3 .3 1.1 1.8 1.9 1.

600. 2.000. Distemper painting costs Rs.250.566 EAC (Distemper Painting) = = = Since EAC of distemper painting is less than that of plastic emulsion.2.000 860. Plastic emulsion for a building costs Rs.000.8) 600000 / 4. CHAPTER 15 1.133.and 4 would be accepted because the expected returns on these projects exceed 15%. The operating costs are expected to be as follows: Year 1 2 3 4 5 Operating Costs (in Rs. The initial outlay on a security system would be Rs.4) 250000 / 2.000 and has a life of 4 years.600. it is the preferred alternative.000 and has a life of 8 years. How does the UAE of plastic emulsion painting compare with that of distemper painting if the cost of capital is 15 percent? Solution: EAC (Plastic Emulsion) = = = 600000 / PVIFA (15%.000 530.87.855 Rs.000 400.) 500.720 250000 / PVIFA (15%. we find that all the four projects need to be rejected. An appropriate basis for accepting or rejecting the projects would be to compare the expected rate of return and the required rate of return for each project.487 Rs.000.000 720. What is the UAE if the cost of capital is 12 percent? . Based on this comparison.000 The estimated salvage value at the end of five years is Rs.

1) + 720 000 x PVIF (12%.5) 900 000 + 100 000 x 0.3) + 240 000 x PVIF (16%.567 .4) + 400 000 x PVIF (12%.743 + 290 000 x 0.836/ 3.552 + 140 000 x 0.2) + 860 000 x PVIF (12%.712 + 530 000 x 0.458.100 000 x PVIF (16%.856.000 4 240.4) + 140 000 x PVIF (16%.600 000 x 0.000 3 290.476 = 1.3) + 530 000 x PVIF (12%.000 2 182.) 1 100.582 .458.069.476 .000 5 140.600 000 x PVIF (12%.5) . 5) 3856340/ 3.000. 3856340 / PVIFA (12%.2) + 290 000 x PVIF (16%.458.Solution: PV of the net costs associated with the security system = 2 000 000 + 500 000 x PVIF (12%.900.000 The estimated salvage value at the end of five years is Rs.000. What is the UAE if the cost of capital is 16 percent? Solution: PV of the net costs associated with the internal transportation system = 900 000 + 100 000 x PVIF (16%.862 + 182 000 x0.641 + 240 000 x 0.5) 1.340 = EAC of the security system = = 3.893 + 720 000 x0.605 = 1.836 = EAC of the internal transportation system = = 1. The operating costs are expected to be as follows: Year Operating Costs (in Rs.720 The initial outlay for an internal transportation system would be Rs.100 000 x 0.274 = 445.5) .836/ PVIFA (16%.100.1) + 182 000 x PVIF (16%.567 = 3.5) 2 000 000 + 500 000 x 0.797 + 860 000 x 0.636 + 400 000 x 0.

78 16. the first instalment falling due at the end of the second year.1900 million.857 0. 5 yrs) What is the adjusted NPV if the adjustment is made only for the issue cost of external equity? Solution: 1100 = 1222. carrying an interest rate of 8 percent per year payable annually. The effective tax rate for the company is 30 percent (i) What is the base case NPV? Solution: The base case NAV = -1900 = -1900 = -23.681 PV 17.99 .800 million for the project.06 3.10 Issue cost = Rs.6 4.4 9. 122.600 million per year for 5 years.794 0.4.2 19.146. The opportunity cost of capital is 18 percent.2 million Adjusted NPV considering only the issue cost = -23.8 (ii) + 600 x PVIFA + 600 x 3. The issue cost is expected to be 10 percent. It is expected to generate a net cash inflow of Rs.27 55.0 million (iii) Solution: What is the present value of the tax shield? Year 1 2 3 4 5 Debt outstanding at beginning 800 800 600 400 200 Interest 64 64 48 32 16 Tax shield 19.45 11. Hansen Electricals is evaluating a capital project requiring an outlay of Rs.2 1 – 0.735 0.926 0.43 7. The balance amount required for the project can be raised by issuing external equity. Hansen Electricals can raise a term loan of Rs.2 14.8 .127 (18%. The principal amount will be repayable in 4 equal annual instalments.122.8 PV @ 8% discount rate 0.2 = .

The balance amount required for the project can be raised by issuing external equity.751 13.34 = -85.400 million per year for 6 years.09) = 659.621 3.34 Adjusted NPV for issue cost = -26 -59.63 3 540 54 17. The effective tax rate for Alok Appliances is 33 percent.1500 million.38 4 360 36 11. It is expected to generate a net cash inflow of Rs.900 million for the project.34 (iii) Solution: What is the present value of the tax shield? Year Debt outstanding Interest Tax shield PVIF@ 10% PV of tax shield at the beginning ------------------------------------------------------------------------------------------------1 900 90 29. Alok Appliances is evaluating a capital project requiring an outlay of Rs.00 2 720 72 23. the first instalment falling due at the end of the first year. The issue cost is expected to be 9 percent.11 5 180 18 5. The opportunity cost of capital is 16 percent.683 8. Alok Appliances can raise a term loan of Rs.88 0.685 = -26 (ii) What is the adjusted NPV if the adjustment is made only for the issue cost of external equity? Solution: 600 / (1-0. (i) What is the base case NPV? Solution: Base case NPV = -1500 + 400 PVIFA (16%.69 -------71.82 0.5. carrying an interest rate of 10 percent per year payable annually.81 .70 0. 6) = -1500 + 400 x 3.76 0.94 0.34 Additional equity to be raised = 59. The principal amount will be repayable in 5 equal annual instalments.826 19.909 27.

07 Issue cost = Rs.000 = 1075 .81 18. It is expected to generate a net cash inflow of Rs.917 0.75.92 – 75.6.800 million for the project.708 0. Mitra Chemicals is evaluating a capital project requiring an outlay of Rs.784 = .3 million (iii) What is the present value of the tax shield? Solution: Year 1 2 3 4 5 Debt outstanding at beginning 800 800 600 400 200 Interest Tax shield 72 72 54 36 18 21.167.51 7.772 0. The opportunity cost of capital is 15 percent.3 1 – 0.8 5.2 10.92 (ii) Solution: What is the adjusted NPV if the adjustment is made only for the issue cost of external equity? 1. The term loan will carry an interest of 9 percent per year payable annually. The balance amount required for the project can be raised by issuing external equity.3 = .842 0.19 12.3 million Adjusted NPV considering only the issue cost = . The principal amount will be repayable in 4 equal annual instalments.67 . 6 yrs) = .6 16. the first instalment falling due at the end of the second year.65 3. The effective tax rate for the company is 30 percent (i) What is the base case NPV? Solution: -1800 + 500 x PVIFA ( 15 %.6 21.1800 million.51 61.500 million per year for 6 years.1800 + 500 x 3. The issue cost is expected to be 7 percent.650 PV 19. Mitra Chemicals can raise a term loan of Rs.4 PV @ 9 % discount rate 0.

CHAPTER 18

1.

Bearings Limited received a subscription for 390,000 shares as against 500,000 shares that were offered and fully underwritten. The underwritten commitments of 5 underwriters P, Q, R, S, and T are as under:
Underwriting commitment 90,000 P Q 80,000 R 100,000 S 130,000 T 100,000 Shares procured 70,000

70,000 85,000 115,000 120,000

Determine the liability of each underwriter.
Solution: Underwriting commitment P Q R S Shares procured Excess/ shortfall Credit Net shortfall

90,000 80,000 100,000 130,000 100,000

70,000 70,000 85,000 115,000 120,000

(20,000) (10,000) (15,000) (15,000) 20,000

4500 4000 5000 6500

(15,500) (6,000) (10,000) ( 8,500)

T

2.

Welcome Industries received a subscription for 850,000 shares as against 1,000,000 shares that were offered and fully underwritten. The underwritten commitments of 4 underwriters M, N , O and P are as under:
Underwriting commitment 200,000 M N 300,000 O 400,000 P 100,000 Shares procured 160,000

220,000 345,000 125,000

Determine the liability of each underwriter.

Solution: Underwriting commitment M N O P Shares procured Excess/ shortfall Credit Net shortfall

200,000 300,000 400,000 100,000

160,000 220,000 345,000 125,000

(40,000) (80,000) (55,000) 25,000

5556 8333 11111

(34,444) (71,667) (43,889)

3.

The equity stock of Paramount Corporation is selling for Rs.240 per share. The firm is planning to issue rights shares in the ratio of one right share for every existing four shares: (a) (b) (c) What is the theoretical value of a right if the subscription price is Rs.220? What is the ex-rights value per share if the subscription price is Rs.210? What is the theoretical value per share when the stock goes ex-rights, if the subscription price is Rs.240? Rs.200?
Po = Rs.240 N=4

Solution:

a.

The theoretical value of a right if the subscription price is Rs.220
Po – S

240 – 220 = = Rs.4 4+1 4 x 240 + 210 = = Rs.234 4+1 4 x 240 + 240 = Rs.240 4+1 4 x 240 + 100 = Rs.212 4+1

N+1 NPo + S N+1

b. The ex-rights value per share if the subscription price is Rs.210

c.

The theoretical value per share, ex-rights, if the subscription price is Rs.240? 100?

4.

The equity stock of Parakram Limited is selling for Rs.860 per share. The firm is planning to issue rights shares in the ratio of one right share for every existing three shares: (a) (b) (c) What is the theoretical value of a right if the subscription price is Rs.800 ? What is the ex-rights value per share if the subscription price is Rs.820 ? What is the theoretical value per share when the stock goes ex-rights, if the subscription price is Rs.860? Rs.700?
Po = Rs.860 N=3

Solution:

a.

The theoretical value of a right if the subscription price is Rs.800
Po – S

860 – 800 = = Rs.15 3+1 3 x 860 + 820 = = Rs.850 3+1 3 x 860 + 860 = Rs.860 3+1 3x 860 + 700 = Rs.820 3+1

N+1 NPo + S N+1

b. The ex-rights value per share if the subscription price is Rs.820

c. The theoretical value per share, ex-rights, if the subscription price is Rs.860? 700?

CHAPTER 19

1.

Advaith Corporation has a net operating income of Rs.50 million. Advaith employs Rs.200 million of debt capital carrying 12 percent interest charge. The equity capitalisation rate applicable to Advaith is 14 percent. What is the market value of Advaith under the net income method? Assume there is no tax.

Solution:

Net operating income (O) Interest on debt (I) Equity earnings (P) Cost of equity (rE) Cost of debt (rD) Market value of equity (E) Market value of debt (D) Market value of the firm (V)

: : : : : : : :

Rs.50 million Rs.24 million Rs.26 million 14 % 12 % Rs.26 million/0.14 =Rs.185.7 million Rs.24 million/0.12 =Rs.200 million Rs.385.7 million

2.

Kanishk Limited has a net operating income of Rs.100 million. Kanishk employs Rs.800 million of debt capital carrying 10 percent interest charge. The equity capitalisation rate applicable to Kanishk is 13 percent. What is the market value of Kanishk under the net income method? Assume there is no tax.

Solution:

Net operating income (O) Interest on debt (I) Equity earnings (P) Cost of equity (rE) Cost of debt (rD) Market value of equity (E) Market value of debt (D) Market value of the firm (V) 3.

: : : : : : : :

Rs.100 million Rs.80 million Rs.20 million 13 % 10 % Rs.20 million/0.13 =Rs.153.8 million Rs.80 million/0.10 =Rs.800 million Rs.953.8 million

The following information is available for two firms, Anil Corporation and Sunil Corporation. Anil Sunil Net operating income Interest on debt Cost of equity Cost of debt Rs.3,200,000 Nil 16 % 12 % Rs.3,200,000 480,000 16% 12 %

Calculate the market value of equity, market value of debt, and market value of the firm for Anil Corporation and Sunil Corporation. (a) (b) What is the average cost of capital for each of the firms? What happens to the average cost of capital of Anil Corporation if it employs Rs.50 million of debt to finance a project that yields an operating income of Rs.5 million? What happens to the average cost of capital of Sunil Corporation if it sells Rs.4 million of additional equity (at par) to retire Rs.4 million of outstanding debt?

(c)

In answering the above questions assume that the net income approach applies and there are no taxes.
Solution:

Anil Market value of equity Market value of debt Market value of the firm 3,200,000/0.16 = Rs.20 million 0 Rs.20million

Sunil 3,200,000/0.16 = Rs.20 million 480,000/0.12 =Rs.4 million 24 million

(a)

Average cost of capital for Anil Corporation 20 x 16% + 20 20 0 x 12% = 16 %

Average cost of capital for Sunil Corporation 20 x 16% + 24 (b) 24 4 x 12% = 15.33 %

If Anil Corporation employs Rs.50 million of debt to finance a project that yields Rs.5 million net operating income, its financials will be as follows. Net operating income Interest on debt Equity earnings Cost of equity Cost of debt Market value of equity Market value of debt Market value of the firm Average cost of capital 13.75 16% 63.75 x 63.75 50 + 12% x = 12.86 % Rs.8,200,000 Rs.6,000,000 Rs.2,200,000 16% 12% Rs.13.75million Rs.50 million Rs.63.75 million

(c)

If Sunil Corporation sells Rs.4 million of additional equity to retire Rs.4 million of debt , it will become an all-equity company. So its average cost of capital will simply be equal to its cost of equity, which is 16%.

4.

The management of Janata Company, subscribing to the net operating income approach, believes that its cost of debt and overall cost of capital will remain at 7 percent and 14 percent, respectively. If the equity shareholders of the firm demand a return of 25 percent, what should be the proportion of debt and equity in the firm’s capital structure? Assume that there are no taxes.

Solution: rE = rA + (rA-rD)D/E 25 = 14 + (14-7) D/E So, D/E = 1.57

5.

The management of Lavanya Corporation, subscribing to the net operating income approach, believes that its cost of debt and overall cost of capital will remain at 10 percent and 16 percent, respectively. If the equity shareholders of the firm demand a return of 22 percent, what should be the proportion of debt and equity in the firm’s capital structure? Assume that there are no taxes.

Solution: rE = rA + (rA-rD)D/E 22 = 16 + (16-10) D/E So D/E = 1.0

6.

The management of a firm believes that the cost of equity and debt for different proportions of equity and debt in the capital structure are as follows
Proportion of Equity Proportion of Debt Cost of Equity, rE% Cost of Debt, rD%

1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90

15.0 16.0 16.5 17.0 17.5 18.0 18.5 19.0 19.5 20.0

7.0 7.5 8.0 8.5 9.0 9.5 10.0 11.0 12.0 14.0

What is the optimal capital structure of the firm?
Solution: E D+E D D+E rE (%) rD (%) rA = E rE + D+E D rD D+E

0 9.00 0.0 18.60 0.70 0. 7.5 8.70 minimises the WACC .5 20.0 12.90 0.20 0.20 0.0 16.100 million = 35 percent = Rs.00 0.75 13.0 7.5 9.0 17.80 0.60 as the firm’s financial flexibility in that case is more.belongs 0.40 13.45 14.5 19.50 0.according to Modigliani and Miller hypothesis is Expected operating income = Discount rate applicable to the risk class to which Vidyut Corporation.0 15.0 8.0 15.0 16.5 17.714 million .40 0.50 14.60 or 0.70 0.60 The debt ratios 0.14 100 = Rs.30 0.10 13.0 11.80 0.40 0.60 0.30 0.12 percent The value of Vidyut Corporation.250 million = Rs.0 14.0 7. The following information is available on Vidyut Corporation.5 18.10 0.50 0.15 14.40 13.90 15.0 19.according to Modigliani and Miller? Solution: = Rs.5 10. The optimal ratio is 0. Net operating income Tax rate Debt capital Interest rate on debt capital Capitalisation rate applicable to debt-free Firm in the risk class to which Vidyut Corporation belongs = 14 percent What should be the value of Vidyut Corporation .10 0.1.8 14.

21 or 21 paise .20) = 0. tpe = 10%. according to Modigliani and Miller hypothesis is Expected operating income 80 = = Rs.14 percent Solution: The value of Magnificent Corporation.8.tpd) = 1- (1-0.15 risk class to which Magnificent Corporation.3) (1-0. and tpd = 20%. belongs = 15 percent What should be the value of Magnificent Corporation. If tc = 30%. The following information is available on Magnificent Corporation. what is the tax advantage of a rupee of debt? Solution: (1-tc) (1 – tpc) 1(1 .belongs 9.150 million = Rs..80 million = 33 percent = Rs. according to Modigliani and Miller? = Rs. Net operating income Tax rate Debt capital Interest rate on debt capital Capitalisation rate applicable to debt-free Firm in the risk class to which Magnificent Corporation.533 million Discount rate applicable to the 0.10) (1 – 0.

34%. 3 per share) Retained Earnings (i) 16 70 21 49 18 31 200 500 350 150 What should have been the ROI of Red Rock Limited for it to meet its target ROE of 20 percent? Note that the pre-tax cost of debt is 8 percent. tpe = 10%.8 ) 2 / 3 ] ( 1 . in crore Shareholders’ Funds 300 Paid up capital : 60 (Equity shares of par value Rs.tc ) [ ROI + ( ROI . The profit and loss account for the year 1 (the year that has just ended) and the balance sheet at the end of year 1 for Red Rock Limited are as follows.10) (1 – 0. Solution: [ ROI + ( ROI .10) Reserves and Surplus: 240 Loan Funds Application of Funds Net fixed assets Net current assets Interest PBT Tax (tc = 30%) PAT Dividends (Rs. Profit and Loss Account Balance Sheet Sales PBIT Rs.22 or 22 paise CHAPTER 20 1. .35) (1-0.3) ROI = = = 20% 20% 20 .25) = 0.in crore 520 86 Sources of Funds Rs. and tpd = 25 %.r) D / E ] ( 1 .tpd) = 1- (1-0.0. what is the tax advantage of a rupee of debt? Solution: (1-tc) (1 – tpc) 1(1 .10. If tc = 35%.

6 crore equity shares of Rs 10 par at Rs.6 ( EBIT . 92 crore.0. What is the EPS-EBIT indifference point? Solution: ( EBIT – 16) ( 1 – 0.200 crore of debentures carrying 8 percent interest rate. 200 crore of external financing for which it is considering two alternatives: Alternative A : Issue of 1. Alternative B : Issue of Rs. The profit and loss account for year 1 (the year which has just ended) and the balance sheet at the end of year 1 for Glendale are as follows: Balance Sheet Sources of Funds • Shareholders’ Funds Profit and Loss Account Rs in crore Sales 500 PBIT 80 Interest 10 Rs.32 ) ( 1 . in crore 260 Paid up capital : 60 (Equity shares of Rs.(ii) Red Rock Limited requires Rs. 125 each.10 par) Reserves & surplus : 200 • Loan Funds Application of Funds • Net Fixed Assets • Net Current Assets 100 360 250 110 360 PBT Tax (tc=30%) PAT Dividends (Rs.3 ) EPSB = 6 Equating EPSA and EPSB gives EBIT = Rs.3 per share) Retained earnings 70 21 49 18 31 (i) What should have been the ROI of Glendale Company to meet a target ROE of 25 percent? Note that the pre-tax cost of debt is 10 percent . 2.3 ) EPSA = 7.

40 million of external financing. Alternative B : Issue of Rs.000 preference shares. (b) Define the alternative which maximises EPS for various levels of EBIT.000 equity shares for Rs.4 ⇒ EBIT = Rs.10 each. The earnings per share is Rs.10) 0.385] (1 – 0.000.Solution: [ROI + (ROI – r) D/E] (1 – tc) = 25% [ROI + (ROI – .25 million.4.4 crore shares at Rs. The firm’s current EBIT is Rs.90 crore 0.125 each. Two financing alternatives are being considered: (i) issuing 4.3) EPSB = 6 Equating EPSA and EPSB gives 0.3 per share.3) = 25% ⇒ ROI = 28.50 crore of external financing for which it is considering two alternatives: Alternative A : Issue of 0. (ii) issuing debentures for Rs.57% (ii) Glendale Company requires Rs.3) EPSA = 6.4 (EBIT – 15) (1 – 0.40 million carrying 12 percent interest.50 crore of debentures carrying 10 percent interest rate.7 EBIT – 7 = 6. Required (a) Compute the EPS-EBIT indifference point. The firm is planning to raise Rs.000 equity shares and 100.5 6.000.0 3. . What is the EPS-EBIT indifference point? Solution: (EBIT – 10) (1 – 0.7 EBIT – 10. A company’s present capital structure contains 4. Preference shares carry a dividend of Rs.

000 The EPS – EBIT indifference point can be obtained by equating EPSA and EPSB (EBIT – 0 ) (1 – 0.000 =2(0.652 EBIT -300.000 – 0 ) (1-t) – 300.800.000 EPSB = 4.652 EBIT = 6. .060.800.000.000.000 0.10 million debentures carrying 15 per cent interest (EBIT – 4. When EBIT exceeds Rs.000 EBIT = Rs 25 million Interest = 0 Preference dividend = Rs.000 (EBIT – 4.000 Financing Plan B : Issue of Rs. of shares = 4.000 Hence t = 0.000 = 8.348) .000) 0.000 EPSA = 8.000) (1-0.123 equity financing maximises EPS.129.000 = Rs. 10.652 EBIT-3.10.348) – 300.Solution: Currently No.348) – 300.4 (EBIT – Interest) (1-t) – Preference dividend EPS = (a) No. of shares (25.123 debt financing maximises EPS.300.3 x 100.000.000) (1 – 0.060.000.000 shares (EBIT .600 -300.000.000.8 per cent The EPS under the two financing plans is : Financing Plan A : Issue of 4.3 million EPS = Rs.123 (b) As long as EBIT is less than Rs.559.348) – 300.200 or EBIT = 10.000.000.0.060.000 4.0 ) ( 1 – 0.348 or 34.000 4 = 4.

What is the probability that the debt alternative is better than the equity alternative with respect to earnings per share .5 23 Alternative 2 EPS = ( PBIT – 3.8 million equity shares at Rs.10 par at Rs.2 million.35) – 1. Alternative 2 : Issue of 2 million equity shares of Rs.65 PBIT – 2. Keerthinath Corporation presently has two million outstanding equity shares (Rs.4.15 each and debentures for Rs.5 million preference shares of Rs. It needs Rs.6 million per year with a standard deviation of Rs. BGM Limited’s present capital structure consists of 20 million equity shares of Rs.13 = 0.10 each.65 PBIT PBIT 5. It is considering two alternatives: Alternative 1 : Issue of 3 million equity shares of Rs.335 = 25.60 million of external financing.11 per share and no outstanding debt .95 PBIT – 49.30 million carrying an interest rate of 11 percent The company’s tax rate is 35 percent? What is the EPS-PBIT indifference point? Solution: Alternative 1 EPS = ( PBIT – 0) (1 – 0. Keerthinath Corporation’s tax rate is 35 percent.3) (1 – 0.10 par) selling at Rs. issue of debt capital carrying 14 percent interest.10 par.65 PBIT – 1.335 = 16. carrying a dividend rate of 10 percent.10 per share.15 each and 1.10 par at Rs. The expected earnings before interest and taxes after the new funds are raised will be Rs.8 million of additional funds which can be raised in two ways: (a) (b) issue of 0.145 22 = 14.5 23 14.3 PBIT – 33 0.35) 22 0. It requires Rs.

000) (1 – 0.35) 1.000) = Prob σ EBIT = Prob [z > .00.1587 = 0.8413 + (1.0384 = 1.000 2.11 per share and no outstanding debt.08] = 0.07 percent.Solution: Plan A : Issue 0.8413)/0. It needs Rs.920.800.04 -1)(0.92 million EBIT – EBIT 3.60 million of additional funds which can be raised in two ways: (a) (b) issue of 6 million equity shares at Rs.000 Prob(EBIT>3.3 EBIT or EBIT = 3.000 (EBIT – 1.35) = 2. we get (EBIT – 0 ) (1 – 0.000 (EBIT – 1.92 – 6.000.05.1.10 par) selling at Rs.8413 when z = -1.35) EPSA EPSB = 2.000 > 2.120.8531 By extrapolation we have Prob [z > . . the probability is = 1-0.120.35) = 2. (EBIT – 0 ) (1 – 0. 6.000 Equating EPSA and EPSB.92million Thus the debt alternative is better than the equity alternative when EBIT > 3.04] From the tables we have when z = -1.000. 10 per share. Innovation Limited presently has 10 million outstanding equity shares (Rs.8531 -0.8 million equity shares at Rs. the probability is = 1-0.8507 or 85.10 per share.2.05 = 0.8 million of debt carrying interest rate of 14 per cent.800. Plan B : Issue Rs.1469 = 0. issue of debt capital carrying 11 percent interest.82 EBIT -2.000) (1 – 0.

Innovation Limited tax rate is 33 percent. The financial leverage ratio is 0.72 EBIT -70.000.6 million EBIT – EBIT Prob(EBIT>17.6 – 16.16 million per year with a standard deviation of Rs.000. (EBIT – 0 ) (1 – 0.000) (1 – 0.2] = 0.4 % .8 and the ROI is 15 percent.7 EBIT or EBIT = 17.33) EPSA EPSB = 16.33) 10. What is the ROE for the company.33) = 10.4207 or 42.The expected earnings before interest and taxes after the new funds are raised will be Rs. Plan B : Issue Rs.000.000) = Prob σ EBIT 17. 10 per share. Hurricane Transport has an average cost of 10 percent for debt financing. What is the probability that the debt alternative is better than the equity alternative with respect to earnings per share. Solution: Plan A : Issue 6 million equity shares at Rs.60 million of debt carrying interest rate of 11 per cent.000 Equating EPSA and EPSB .752 = 6.07 % 7. if its tax rate is 40 percent? Solution: ROE = [15 + (15 – 10 ) 0.8 million.000) (1 – 0.000 (EBIT – 6.6 million Thus the debt alternative is better than the equity alternative when EBIT > 17.000 10.000 (EBIT – 6.000. we get (EBIT – 0 ) (1 – 0.600.600.0 > 8 = Prob [z > 0.8 ] (1 – 0.4) = 11.600.33) = 16.

Interest coverage ratio = Interest on debt 35 = 7 = 5.628 1.65 10.125 million Rs.0 EBIT + Depreciation b.628 ROI = 23.072 ROI = 25.6 and its tax rate is 33 percent.91 % 9. Nanda Enterprises has a target ROE of 20 percent.8.4.on debt + (1 – Tax rate) = 35 + 5 = 3.67 ROI +0. What ROI should the company plan to earn? The cost of debt is 14 percent. The financial leverage ratio for the firm is 0. The following information is available about Excalibur Limited.402 ROI – 5.35 million Rs.7 million 35 percent Rs. The following information is available about Notting Hill Corporation.04 7 + 4/0. Solution: EBIT a. (b) Calculate the cash flow coverage ratio.0 million Required: (a) Calculate the interest coverage ratio.5 million Rs.33) = 0. Cash flow coverage ratio = Loan repayment instalment Int. Solution: 20 = [ ROI + ( ROI – 14 ) 0. Depreciation EBIT Interest on debt Tax rate Loan repayment instalment Rs.6 ] ( 1 – 0.52 million . Depreciation EBIT Interest on debt Rs.30 million Rs.

Cash flow coverage ratio = Loan repayment instalment Int.4 Term loan repayment 20.00 instalment Required: Calculate the debt service coverage ratio.on debt + (1 – Tax rate) = 125 + 30 = 1.0 million Required: (a) Calculate the interest coverage ratio. Solution: EBIT a.67 11. Interest coverage ratio = Interest on debt 125 = = b. in million Year 1 Year 2 Year 3 Year 4 Year 5 Profit after tax -3.Tax rate Loan repayment instalment 33 percent Rs.00 20. The following projections are available for Aristocrats Limited: Rs.25 8.20 8.43 6. Solution: 52 2.89 52 + 20/0.00 14.0 11.0 13.33 4.20.00 20.00 Depreciation 15.40 EBIT + Depreciation The debt service coverage ratio for Aristocrats Limited is given by: 5 ∑ ( PAT i + Depi + Inti) i=1 DSCR = 5 ∑ (Inti + LRIi) i=1 . (b) Calculate the cash flow coverage ratio.00 28.75 Interest on term loan 14.0 11.00 25.0 24.00 14.

Rs.00 + 45. the net cash flows of the company.00 100. there is some apprehension about the firm’s ability to meet interest burden during a recessionary year.00 91.60 = = 12.6 61.80 million.0 -1.00 100.92 Interest on term loan 91.00 100.4 81.00 100.800 million are raised as debt finance? .00 instalment Required: Calculate the debt service coverage ratio.200 million with a standard deviation of Rs. The management of the firm is convinced that debt is a cheaper source of finance and is confident that it can raise the entire amount by debt finance (perpetual) at a rate of 12 percent.0 65.62 Jaisurya Associates is embarking on an expansion plan requiring an outlay of Rs.0 52. in million Year 1 Year 2 Year 3 Year 4 Year 5 Profit after tax -4.6 + 60 194. Solution: The debt service coverage ratio for Oscar Corporation is given by : 5 ∑ ( PAT i + Depi + Inti) i=1 DSCR = 5 ∑ (Inti + LRIi) i=1 = 210 + 672.00 80.800 million.76 + 61.6 1.36 121. The management feels that in a recessionary year.0 35. Required: (a) What is the probability of cash inadequacy during a recessionary year . However.00 Depreciation 200 160 128 102. The following projections are available for Oscar Corporation.= 87. if the entire Rs.00 78.0 Term loan repayment 100.32 + 377 377 + 400 = = 13. 1259.32 777 1. would have an expected value of Rs. not taking into account the interest burden on the new debt.

there is some apprehension about the firm’s ability to meet interest burden during a recessionary year. However.45 million. 800 million is raised by way of debt carrying 12 per cent interest. Medicon Limited is embarking on an expansion plan requiring an outlay of Rs. and the Z value corresponding to the risk tolerance limit of 4 per cent is –1.200 million .80 million .0968 (b) Since µ = Rs. the net cash flows of the company. the debt that be serviced is 60 = Rs.75 . Prob(X<0) = Prob (z<.1. Considering the interest burden the net cash flows of the firm during a recessionary year will have an expected value of Rs. . the interest burden will be Rs.3) = 0.75 80 X = Rs. 104 million (Rs.800 million requirement should be raised as debt finance? Solution: (a) If the entire outlay of Rs.150 million with a standard deviation of Rs.Rs. The management feels that in a recessionary year. σ= Rs. Since the net cash flow (X) is distributed normally X – 104 80 has a standard normal deviation Cash flow inadequacy means that X is less than 0. not taking into account the interest burden on the new debt.1.12 14.200 million. 500 million 0. 80 million . would have an expected value of Rs. The management of the firm is convinced that debt is a cheaper source of finance and is confident that it can raise the entire amount by debt finance (perpetual) at a rate of 10 percent. 96 million. 96 million ) and a standard deviation of Rs.600 million.(b) If the management is prepared to accept only a 4 percent chance of cash inadequacy. what proportion of Rs.60 million Given 15 per cent interest rate. the cash available from the operations to service the debt is equal to X which is defined as : X – 200 = .

0) = 0. 465 million 0.10 CHAPTER 21 1.6. the interest burden will be Rs. what proportion of Rs.5 million Given 10 per cent interest rate.2.Rs. the debt than be serviced is 46. 60 million ) and a standard deviation of Rs. if the entire Rs. 60 million.2.30 (approximately) .150 million .150 million. 45 million . 90 million (Rs.00 Rate of return = 18 percent . σ= Rs.Required: (a) What is the probability of cash inadequacy during a recessionary year.30 45 X = Rs.5 = Rs.600 million requirement should be raised as debt finance ? Solution: (a) If the entire outlay of Rs. Considering the interest burden. the net cash flows of the firm during a recessionary year will have an expected value of Rs.46.45 million .600 million are raised as debt finance? (b) If the management is prepared to accept only a 1 percent chance of cash inadequacy. Since the net cash flow (X) is distributed normally X – 90 45 has a standard normal deviation Cash flow inadequacy means that X is less than 0. The following data is available for Newton Limited: Earnings per share = Rs. 600 million is raised by way of debt carrying 10 per cent interest. and the Z value corresponding to the risk tolerance limit of 1 per cent is –2. the cash available from the operations to service the debt is equal to X which is defined as : X – 150 = .0228 (c) Since µ = Rs. Prob(X<0) = Prob (z<.

3)+6(0.18) = 6 x 0.15 6(0.0.60 0. Dividends are taxed at 25 percent and capital gains at 12 percent. 44. Price as per Gordon model P0 =E1(1-b)/(k-br) = 6 x 0. what will be the price per share when the dividend payout is 30 percent.85. if each of them offers an expected posttax rate of 18 percent? Assume that the radical position applies .6) 0. investors expect a pay off of Rs 100 – Rs 10 by way of dividend and Rs 90 by way of share price a year from now. 45.40)+6(0.15 .15 = Rs.70/(0.0. 175 =Rs.18 0.60x 0. what will be the price per share when the dividend payout ratio is 30 percent? 40 percent? (b) If Gordon's basic valuation formula holds. What will be the current price of the shares of A and B.to be worth Rs 100 next year.7) x 0.15 = Rs. too.18 0.15 . Investors expect the share of firm A – the firm which does not plan to pay dividend -.70x 0. From the share of firm B.60/(0.40 0. 40 percent? Solution: (a) Payout ratio Price per share 6(0.80 The stocks of firms A and B are considered to be equally risky.18) =Rs.3 0.15 (b) Dividend payout ratio 30 % 40% 2.7 0.Cost of capital = 15 percent (a) If Walter’s valuation formula holds.

2 a year from now from one share of Suman Company: Rs.8 x 20 0.88(100-A) 0 0. investors expect a pay off of Rs 180 – Rs 20 by way of dividend and Rs 160 by way of share price a year from now. Dividends are taxed at 20 percent and capital gains at 10 percent.45 4.2 by way of dividend and Rs. Investors expect the share of firm M – the firm which does not plan to pay dividend -. Assume that investors expect a payoff of Rs.147.145.81. What will be the current price of the shares of M and N.27 N 160 20 N (160-N) 0. too.88 (100-A) A = 18% A = Rs. if each of them offers an expected post-tax rate of 20 percent? Assume that the radical position applies Solution: • • • • • • • Next year’s price Dividend Current price Capital appreciation Post-tax capital appreciation Post-tax dividend income Total return • Current price (obtained by solving the preceding equation) M 180 0 M (180-M) 0.9 (180-M) M = 20 % M= Rs.83.5 B =18% B = Rs.9 (160-N) 0. If dividend is taxed at 10 percent and capital appreciation is taxed at 20 percent.to be worth Rs 180 next year.305. 5.79 3.9 (160-N) + 16 N =20 % N= Rs. From the share of firm N.88 (90-B) + 7.02 B 90 10 B (90-B) 0. what will be the current price of Suman Company’s share if investors expect a post-tax return of 14 percent? Solution: .75 x 10 0.88 (90-B) 0. The stocks of firms M and N are considered to be equally risky.Solution: • • • • • • • Next year’s price Dividend Current price Capital appreciation Post-tax capital appreciation Post-tax dividend income Total return • Current price (obtained by solving the preceding equation) A 100 0 A (100-A) 0. 300 by way of share price.9(180-M) 0 0.

000 60.2) 0.000 outstanding shares currently on which it pays a dividend of two rupees per share.Let the current price of the share be = Price one year hence Capital appreciation Dividend Post tax capital appreciation Post tax dividend income Total return = P = = = = = 300 (300 – P) 5.16 = 0.14 0.62 CHAPTER 22 1.16 P = Rs.000 The company has 10.000 6.2 0. Under a pure residual dividend policy.000 Capital Expenditures (Rs. The debt. Handsome Apparels expects that its net income and capital expenditures over the next four years will be as follows: Year 1 2 3 4 Net Income (Rs.9P + 4.04P = 274.equity target of the firm is 1:1 Required: (a) What will be the dividend per share if the company follows a pure residual policy? (b) What external financing is required if the company plans to raise dividends by 15 percent every 2 years? (c) What will be the dividend per share and external financing requirement if the company follows a policy of a constant 50 percent payout ratio? Solution: a.9 (300 – P) + 4. 263.8 (5.000 10.) 12.16 = P 270 – 0.000 34.000 7.9 (300 – P) 0.) 40.14P 1.000 25. the dividend per share over the 4 year period will be as follows: .

C.05 b.000 34.30 23. D.000 3.000 5.000 6.000 2.000 0 c.000 12. E.000 5.000 2. F.000 22.000 3.000 25.500 7.000 37.000 2.) Year 1 2 3 4 Earnings Capital expenditure Equity investment Pure residual dividends Dividends per share 40.30 23.000 10.) Year 1 2 3 4 A.000 2.5 25.00 20.000 2.000 20.DPS Under Pure Residual Dividend Policy (in Rs.000 2.4 60.000 6.500 30.000 3.500 7.000 12. B.000 34.000 External financing requirement 0 (E-D)if E > D or 0 otherwise 0 4.000 10.000 60. the dividend per share and external financing requirement over the 4 year period are given below .2 34.000 55. The external financing required over the 4 year period (under the assumption that the company plans to raise dividends by 15 percents every two years) is given below : Required Level of External Financing (in Rs. Net income Targeted DPS Total dividends Retained earnings(A-C) Capital expenditure 40.000 6.65 26.500 3.000 7. Given that the company follows a constant 50 per cent payout ratio.

000 12.000 60.000 4.70 2. Dividends C. Retained earnings 40.000 85.) 25.) Year 1 2 3 4 A.500 12.equity target of the firm is 3:2 Required: a.00 1.Dividend Per Share and External Financing Requirement (in Rs. Net income B. What will be the dividend per share if the company follows a pure residual policy? b. or 0 otherwise F.000 50.000 30. The debt.000 14.000 20. What will be the dividend per share and external financing requirement if the company follows a policy of a constant 60 percent payout ratio? .000 10.000 38. Dividends per share 0 0 0 0 2.000 outstanding shares currently on which it pays a dividend of two rupees per share. What external financing is required if the company plans to raise dividends by 20 percent every 3 years? c.000 The company has 20.000 17.000 6.25 1.000 7.000 17.000 E.500 34.) 70.000 57.000 Capital Expenditures (Rs.000 30.000 D.000 40. Capital expenditure 12. External financing (D-C)if D>C. Young Turk Associates expects that its net income and capital expenditures over the next five years will be as follows: Year 1 2 3 4 5 Net Income (Rs.000 105.000 20.000 25.00 3.

000 40.400 Dividends per share 3.000 2.000 57.000 37. B. The external financing required over the 5 year period (under the assumption that the company plans to raise dividends by 20 percents every three years) is given below: Required Level of External Financing (in Rs. E.00 0 50. Under a pure residual dividend policy.00 40.000 14.000 38.0 4.000 14.40 40.000 50.000 1. Given that the company follows a constant 60 per cent payout ratio.200 99.40 105.000 60. F.000 4.000 2.17 0.000 Equity investment Pure residual dividends 10.000 0 67.000 38.000 48.000 48. the dividend per share over the 4 year period will be as follows: DPS Under Pure Residual Dividend Policy Year Earnings Capital expenditure ( in Rs. C.76 4.000 0 External financing requirement 0 (E-D)if E > D or 0 otherwise c.000 20.000 30. Net income Targeted DPS Total dividends Retained earnings(A-C) Capital expenditure 70.000 48.000 105.) Year 1 2 3 4 5 A.000 85. the dividend per share and external financing requirement over the 5 year period are given below .000 25.000 4.Solution: a.) 1 2 3 4 5 70.000 2.000 85.40 2.600 15.400 22.000 57.0 1.000 -10.600 83.800 5.000 50. D.000 40.000 2.97 b.000 20.000 57.000 25.

5 2.000 51.000 28.r.000 4.55 38. Dividends C.000 15. r.000 34.15 3.4) x 4 = Rs.100 million can be treated as a tax-deductible expense.35 x 8 ) + ( 1 – 0.000 million and Primtech incurred floatation costs of Rs.6 x 0.800 63. EPS1 + (1 – c) Dt – 1 = (0.24.000 million 11 percent (coupon rate) bond issue outstanding which has 4 years of residual maturity.000 24.000 0 2.) Year 1 2 3 4 A. Primtech can call the bonds for Rs. Primtech’s tax rate is 30 percent.000 22.Dividend Per Share and External Financing Requirement (in Rs.5.000 50. External financing (D-C)if D>C.48 million which are being amortised for tax purposes at the rate of Rs.000 1.14 0 3. The bonds were issued four years ago at par for Rs.20 and the target payout ratio is 30% and adjustment rate is 0.000 0 2.2. Assume that the call premium of Rs. Primtech Limited has a Rs. if the expected EPS for that year is Rs. the amortised portion of the floatation costs (Rs.000 41. Net income B.1 40.8 ) x 2.2 Dt = c.3 x 20) + (0.000 105.800 1.000 42.50 = 2. The dividend per share of a firm for the current year is Rs. What will be the expected dividend per share of a firm for next year.8 x 0.000 14.2 85. If the bonds are called. or 0 otherwise F.000 25.2. Retained earnings D.24 + 0. Dividends per share 70.6? Assume that the Lintner model applies.200 42. .74 1.000 34.000 16.000 57. Solution: Dt = c.EPS1 + ( 1 – c ) Dt – 1 = = CHAPTER 23 ( 0.4.6 million per year.2100 million.0 million) can be deducted for tax purposes. Capital expenditure F.

Tax savings on interest expense and amortisation of issue expenses 0.30 [100 + 24] (d) Initial outlay: (a) – (b) – (c) Rs. (i) Solution: What will be the initial outlay? (a) Cost of calling the old bonds Face value Call premium (b) Net proceeds of the new issue Gross proceeds .Tax saving on interest expense and amortisation of issue expenses : 0.3 (180 + 10 ) 180 57 123. 37.3 (220 + 6) 220 67.000 million of new bonds at an interest rate of 9 percent and use the proceeds for refunding the old bonds. which can be amortised in 4 equal instalments for tax purposes.2000 million 100 million 2100 million Rs.8 152.2 (c) Annual net cash savings: (a) – (b) . The new issue will have a maturity of 4 years and involve a floatation cost of Rs.2 (b) Annual net cash outflow on new bonds Interest expense .Primetech has been advised by its merchant bankers that the firm can issue Rs.2000 million 40 million 1960 million Rs.Issue cost Rs.2 million (c) Tax savings on tax-deductible expenses Tax rate [Call premium + Unamortised issue costs on old bonds] 0.0 29.8 million (ii) Solution: What will be the annual net cash savings? (a) Annual net cash outflow on old bonds Interest expense .2.40 million.102.

09 (1.1200 million of new bonds at an interest rate of 8 percent and use the proceeds for refunding of old bonds.15.063 2. Sanofi Limited has a Rs. The new issue will have a maturity of 4 years and involve a floatation cost of Rs.441 0. The bonds were issued 4 years ago at par for Rs.30 [ 66 + 15 ] (d) Initial outlay: ( a ) – ( b ) – ( c ) Rs.75 million per year.(iii) What is the NPV of refunding the bond? Solution: Present value of annual net cash savings: 29. 11 percent (coupon rate) bond issue outstanding which has 4 years residual maturity.1200 million and Sanofi incurred floatation costs of Rs.063.3 million = Rs.063.7 million .66 million can be treated as a tax-deductible expense.30 million which are being amortised for tax purposes at the rate of Rs.3) = 0. If the bonds are called.1200 million. 65. Sanofi can call the bonds for Rs.48 .063)]4 = = 3. the firm can issue Rs. Sanofi has been advised by its merchant bankers that due to fall in interest rates. Sanofi’s tax rate is 30 percent.Issue costs (c) Tax savings on tax-deductible expenses Tax rate [Call premium + Unamortised issue costs on old bonds] 0. 4 yrs) = 29.0. Assume that the call premium of Rs.2. 24 million.0 million) can be deducted for tax purposes. 1200 million 24 million Rs. 4 yrs) 1 – [1/(1.32 0.2 x 3. (i) What will be the initial outlay? Solution: (a) Cost of calling the old bonds Face Value Call premium (b) Net proceeds of the new issue Gross Proceeds .Initial outlay = 102.2 x PVIFA (0.80 .1266 million. the unamortised portion of the floatation costs (Rs.3. 1200 million 66 million 1266 million Rs.441 = 100. 1176 million 24.063 PVIFA (0. which can be amortised in 4 equal annual instalments for tax purposes.

30 (96 + 6) 96.0 million) can be deducted for tax purposes. ..787 million PVIFA 4.000 40.30) = .400 ( c ) Annual net cash savings ( a ) – ( b ) million (iii) What is the NPV of refunding the bond? Solution: 25. Assume that the call premium of Rs.(ii) Solution: What will be the annual net cash savings? ( a ) Annual net cash outflow on old bonds Interest expense .60 million can be treated as a tax-deductible expense.Tax saving on interest expense and amortisation of issue expenses 0.487 million . Synex can call the bonds for Rs.3.875 x 3.056 ) = -------------------------. If the bonds are called.15.7 million = 24. 10 percent (coupon rate) bond issue outstanding which has 5 years residual maturity.275 ( b ) Annual net cash outflow on new bonds Interest expense .Tax savings on interest expense and amortisation of issue expenses 0.-----------( 1.725 91.1060 million.24 million which are being amortised for tax purposes at the rate of Rs.1000 million and Synex incurred floatation costs of Rs. The bonds were issued 3 years ago at par for Rs.75) = 132.056 4 1 1 .4971 = 25.056 = 3.55% 6 yrs 3.4971 = 90. Synex Limited has a Rs. the unamortised portion of the floatation costs (Rs.875 Present value of annual net cash savings: rd ( 1 – t ) = .1000 million.0 million per year.Initial outlay = -65. Synex’s tax rate is 35 percent.000 30.30 ( 132 + 3.08 ( 1 .600 65.

1000 million of new debt at an interest rate of 7 percent and use the proceeds for refunding of old bonds. 20 million.1 19.1000 million 60 million 1060 million Rs.05 63. (i) Solution: What will be the initial outlay? (a) Cost of calling the old bonds Face value Call premium (b) Net proceeds of the new issue Gross proceeds .75 million (ii) Solution: What will be the annual net cash savings? (a) Annual net cash outflow on old bonds Interest expense .9 44.95 70 25.Issue cost (c) Tax savings on tax-deductible expenses Rs.35 ( 100 + 3) (b) Annual net cash outflow on new bonds Interest expense .1000 million 20 million 980 million Rs.35 [60 + 15] (d) Initial outlay: (a) – (b) – (c) Rs.26. which can be amortised in 5 equal annual installments for tax purposes.Synex has been advised by its merchant bankers that due to fall in interest rates the firm can issue Rs.85 (c) Annual net cash savings : (a) – (b) .25 million Tax rate [Call premium + Unamortised issue costs on old bonds] 0.Tax savings on interest expense and amortisation of issue expenses 0.53. The new issue will have a maturity of 5 years and involve a floatation cost of Rs.Tax saving on interest expense and amortisation of issue expenses : 0.35 ( 70 + 4 ) 100 36.

0526) (1 + r2) 7.0526) r3 = 7.000 + (1.0455.27 million.200 = (1.000 107.000 99. 100.500 99.384 .0526) 7.0.02 53.000 = 95.85 x PVIFA (0.000 Interest rate 0 7% 7% Maturity (years) 1 2 3 Current price 95.000 Rs.33.0526) (1. 100.0948) (1+r3) 107. = = 87. 5 yrs) 1 1.000 Rs.000 r2 = 9.000 99.37 % + (1.48 % r1 = 5.27 Consider the following data for government securities: Face value Rs.200 What is the forward rate for year 3(r3)? Solution: 100.85 x 4.26 % .500 = (1.Initial outlay Rs.35) = 0.0455 5 = 4.384 (iii) What is the NPV of refunding the bond? Solution: = 19.07 ( 1.0948) + (1.0455 PVIFA = 0.000 (1 + r1) 7.0526) (1.75 33. 100.Present value of annual net cash savings: 0. 4.0455 19.000 99.

Consider the following data for government securities: Face value 100. Consider the following data for government securities: Face value 100.500 100.000 Interest rate (%) 0 6% 7% Maturity (years) 1 2 3 Current price 94.000 (1.5.10% > r2 = 6.250 > r1 = 6.061) (1.11% + (1.0549) (1.800 99.0646) 8.01% 94.0711) .0549) (1 + r2) 7000 107000 + (1.000 + (1.0646) (1+r3) = 6.000 100.500 100.061) (1.000 (1+r1) 99.46% 6000 (1.061) r3 + + 106000 (1.500 What is the forward rate for year 3(r3)? Solution: 100.500 = = = 94.49% 106.0549) ⇒ r = 8.0549) (1.250 99.000 100.000 = (1 + r1) 6.01% 107.500 What is the forward rate for year 3(r3)? Solution: 100.000 100.0711) (1 + r3) ⇒ r2 = 7.000 99500 = (1.0610) 7.000 + (1.000 100.000 (1.500 100.0549) 7000 100500 = (1.061) (1+r2) 7.000 Interest rate 6% 7% Maturity (years) 1 2 3 Current price 94.800 ⇒ r1 = 5.

using the approximate formula. A.91 % 0. B and C Bond A Face value Coupon (interest rate) payable annually Years to maturity Redemption value Current market price 12 percent 5 1.305 559.91 0. and (c) volatilities of these bonds? Solution: a) Yield to maturity of bond A. using the approximate formula. is 14 + (100 – 92)/7 = -------------------------= 15. Consider three bonds.201 79.4x1000 + 0.7.98 years .4x100 + 0.89 percent bond's value bond's value x time 104.076 0.6x900 Yield to maturity of bond B.51 0.088 0.620 3.000 13 percent 6 1.101 0.850 100 14 percent 7 100 92 What are the (a) yields to maturity (use the approximate formula) (b) durations.87 0.03 % 0.000 Bond B Bond C 1.45 0.4x1000 + 0.6x92 (b) Solution: Duration of bond A is calculated as under: Year Cash flow 1 120 2 120 3 120 4 120 5 1120 Sum = Present value at Proportion of the Proportion of the 14. using the approximate formula.6x850 Yield to maturity of bond C.89 % 0.116 90.000 Rs.099 902.13 0.900 1.87 Duration = 3.116 0. is 120 + (1000 – 900)/5 = ------------------------= 14.263 68.000 Rs. is 130 + (1000 – 850)/6 = ----------------------------= 17.

8 years Year 1 2 3 4 5 6 7 c) Volatility of bond A 3. What is the net advantage of leasing (NAL) for Optex? .292 14 7.56 0.375 114 40.1489 CHAPTER 24 Volatility of bond B 4.39 years Year 1 2 3 4 5 6 Cash flow 130 130 130 130 130 1130 Sum = Duration of bond C is calculated as under: Present value at Proportion of the Proportion of the Cash flow 15.1 million payable on signing the lease contract.08 0.11 0.42 0. and (ii) borrowing and purchasing the equipment.84 0.Duration of bond B is calculated as under: Present value at Proportion of the Proportion of the bond's 17.08 0. The tax relevant depreciation rate on the equipment is 25 percent as per the WDV method. the lease rental being payable in arrears.130 0.tax cost of debt is 7 percent.440 3.131 14 10.063 0.097 0.284 69.130 94.391 = 3.346 439.222 81.095 0.92 0. There is a management fees of Rs.084 0.22 0. Optex has an effective tax rate of 30 percent and its post. GT capital is willing to lease the equipment to Optex for an annual lease rental of Rs.131 0.76 0.8 = 4.111 0.073 0.1703 Volatility of bond C 4.75 1.081 0.363 14 5.14 million.069 0.91 percent bond's value bond's value x time 14 12. 60 million.984 = 3.47 1.30 0.514 3.69 0.77 0. Optex is considering two alternatives: (i) leasing the equipment. The net salvage value of the equipment after five years is expected to be Rs.336 14 6.113 0.16 million for 5 years.27 Duration= 4. Optex Limited has decided to go for an equipment costing Rs.324 59.077 Sum = 92.226 14 8.085 855.47 Duration= 4.99 0.14 1.03 percent bond's value value x time 111.1591 1.

Loss of depreciation tax shield 6. Depreciation 5. Loss of salvage value 9.5 million.tax cost of debt is 6 percent.731 -13. There is a management fees of Rs. Tax shield on lease payment 8.800 -16. 50 million.680 -14. the lease rental being payable in arrears.531 6. 1 million payable on signing the lease contract.285 2.746 -1. 3.00 0.800 -16.873 -12. Prajay has an effective tax rate of 35 percent and its post.000 +59.00 -1.935 -14.000 4.898 4.10.098 -26.424 -16.000 4. Lease payment 7. in million 5 15.800 -14. The net salvage value of the equipment after five years is expected to be Rs.994 0. Prajay Limited has decided to go for a pollution control equipment costing Rs.000 4.2 million for 5 years. The tax relevant depreciation rate on the equipment is 25 percent as per the WDV method.800 -16.000 4.000 +59.500 11. Cost of plant Management fee Tax shield on Management fee 4.700 -14. Present value Of (9) NAL of leasing 0 +60.13.816 -11. and (ii) borrowing and purchasing the equipment. Present value factors 11. GE capital is willing to lease the equipment to Prajay for an annual lease rental of Rs.724 -11.994 -9.983 -12.204 0.724 0.250 -3.328 -1.30 1 2 3 4 Rs.Solution: 1.000 -4. What is the net advantage of leasing (NAL) for Prajay? .204 = -8.713 -18.000 4. Cash flow of lease (1) + (2) + (3) + (5) + (6) + (7) + (8) 10.800 -16.375 8. Prajay is considering two alternatives: (i) leasing the equipment.438 -2.575 -13.624 1.3 -15. 2.3 59.680 0.983 -18.763 -9.3 0.

Tax shield on Management fee 4. Tax shield on lease payment 8.257 0.861 -11.556 -10.464 1.000 -1.384 -13. Sanjeev Limited has decided to go for an air conditioning plant costing Rs.890 -10.747 -15. 0 +50.620 -13.792 -8. GM capital is willing to lease the plant to Sanjeev Limited for an annual lease rental of Rs.955 -1.461 5.274 -9. Lease payment 7.281 7.287 -15.955 -11. Present value of factor 11.273 -1.375 9.620 -13.556 0. Cash flow of lease (1) + (2) + (3) + (5) + (6) + (7) + (8) 10. 40 million.tax cost of debt is 7 percent.200 4.620 -13.200 4.5 million.350 1 2 3 4 5 12.500 -4.350 0.000 +49.840 -9.241 1.350 -12.000 0. Sanjeev Limited has an effective tax rate of 35 percent and its post. 2.200 4.031 -2.943 -12.287 3.200 4.8.274 0. Loss of depreciation tax shield 6.620 -13.8 million for 5 years. Depreciation 5.10.041 -10. The net salvage value of the plant after five years is expected to be Rs.257 -8. and (ii) borrowing and purchasing the plant.Solution: Cost of plant Management fee 3.426 -20.500 +49.217 -12. The tax relevant depreciation rate on the plant is 25 percent as per the WDV method.620 -10.217 0. What is the net advantage of leasing (NAL) for Sanjeev Limited? .350 49. the lease rental being payable in arrears.846 3.200 4. Sanjeev Limited is considering two alternatives: (i) leasing the plant. Loss of salvage value 9.375 -3. Present value of (9) NAL of leasing = -6.

989 0.500 +40. Present value factor 9.219 -1.Loss of salvage value 7. Genuine Finance offers a hire-purchase proposal for a period of 3 years at a flat interest of 14 per cent. The depreciation rate on the asset is 25 per cent (WDV) and its net salvage value after 10 years would be Rs. Should Shiva choose the hire-purchase or the leasing option? Solution: Under the hire purchase proposal the total interest payment is 3.000.800 3.14 x 3 = Rs.Cash flow of lease (1) +(3) + (4) + (5) + (6) 8.497 0.855 4.320 per Rs.625 -1.420 -8.780 -10.645 0. Thereafter.1.713 -11. Shiva Industries requires an asset costing Rs.335 -8.164 -1.Present value of (7) NAL of Leasing 0 +40000 1 10.500 -2.520 0.Lease payment 5.000 x 0.816 -7.335 -7.855 -11.3 million.780 -10.000 per year for the next 5 years (secondary period).000 40.836 -9.780 -8. Shiva has a tax rate of 35 percent and its post-tax cost of debt is 9 percent. 1.800 3.30.000 -10.836 = -3.780 -10.625 3 5.935 -9.000 40.350.000 1.Cost of plant 2. .477 5 3. the asset would revert to Genuine.420 -8.Depreciation 3.873 -8.107 -10.Solution: 1.260.000.500 2 7. 1.627 0.Tax shield on lease payment 6.000 is allocated over the 3 years period using the sum of the years digits method as follows: .000 The interest payment of Rs.483 -6.800 3.929 -9.000 per year for the first 5 years (primary period) and Rs.Loss of depreciation tax shield 4.800 3. Genuine also gives a lease proposal wherein the lease rental would be Rs.969 4 4.800 3.780 -10.260.763 -6.000 -3.483 -16.

568 Principal repayment Rs.19.406(0.000 Rs.000 = Rs. 1.260.35) 3 -960.000 + Rs.076.000 Rs. 30.19.432 x Rs.500 75.500 100.000.35)= .305(0.30.000 x Rs.000 Rs.000(1-.3. 1.500 133.35) 6 .000 237.875(0.000 per year for the next 5 years The cash flows of the leasing and hire purchase options are shown below Year Leasing .432 Rs.000 .000 = Rs.484(0. .30.000 Rs.000 = Rs.432 (1-. 147.30.000 (1-. 1.432 421.293 46.000 per year for the first 5 years Rs.000(1-.35) 7 .35) 5 -960.149 -1. 1.19.719 35.35)= . 1.057 62.000(1-.000 -692.314(0.500 177.000.500(0.35)= .568 (1-.35)=-624.35) 8 . 1.1.000(0.695 110.260.Year Interest allocation 366 1 666 222 2 666 78 3 666 The annual hire purchase installments will be: Rs. 1.000(1-.35)=-624.710 1 -960. 960.30.420.35)=-624.220.000 562.35) 350.35)= .420.19.113(0.000 Rs.420.500 56.000(1-.35)= . 1.35) 4 -960.35)=-624.35) -1.000(1-.260.000 3 The annual hire purchase installments would be split as follows Year 1 2 3 Hire purchase installment Interest Rs.35) 10 .260.000(1-.432 x Rs.35) 9 .568 Rs.692.727.000 316.35) 2 -960.35)=-624.000.147.35) -1.040 26.125 -1.LRt (1-tc) Hire Purchase -It(1-tc) -PRt Dt(tc) NSVt -It(1-tc)-PRt+ Dt(tc)+NSVt -915.420.568 The lease rental will be as follows: Rs.35) -727.742 83. .272.979(0.000(1-. 420.000(1-. .000 -147.19.085(0.568 750.272. .420.000(1-.000 = Rs.000 -420. 1.280 369.30. 692.

6931 + 0.09)t − 10 ∑ t=6 19.710/(1. Shiva should choose the hire purchase option .09)3+110.500 (1.09)4 +83.5yrs) = -624.890 .500 PVIFA(9%.476.4)2/2]3 0.8665 d1 .306 = -2.500 x 3.09)7 + 35.427.6928 1.040/(1.5yrs) .09)6 + 46.280/(1.293/(1.6 0.2.19.40 • Interest rate : 12 percent What is the value of a warrant? Ignore the complication arising from dividends and/or dilution. Consider the following data: • Number of shares outstanding : 80 million • Current stock price : Rs 60 • Ratio of warrants issued to the number of outstanding shares : 0.890 x 0.09)2 -1.09)8 + 26.076.1737 N (1.666 Present value of the hire purchase option = -915.05 • Exercise price : Rs 30 • Time to expiration of warrant : 3 years • Annual standard deviation of stock price changes : 0.149/(1.12 + (0.000 = -∑ t=1 (1.360 – 49.09) – 1.000 PVIFA(9%.650 = -2.8665).125/(1.19.09)10 = .695/(1.951 Since the hire purchase option costs less than the leasing option. CHAPTER 25 1.Present value of the leasing option 5 624.220.719/(1.057/(1.5yrs) PVIF(9%.09)9+ 369.6928 1.4(3)1/2 0. Solution: l (S/E) + (r + σ2 /2) t d1 = = = = d2 = = = N(d1) = σ√t ln (60 / 30) + [0.000 x 3. .8665 – 0.742/(1.09)5 + 62.306.σ √ t 1.09)t = -624.

5800 0.001155 = 0.8665) = 0.0287= 0.0.0.6 1.8749 N(1.0322= 0.8749 + 0.From the tables we have N(1. The following data is available: • Number of shares outstanding = 60 million • Current stock price = Rs 70 • Ratio of warrants issued to the number of outstanding shares = 8 percent • Exercise price = Rs 40 • Time to expiration of warrants = 4 years • Annual standard deviation of stock price changes = 30 percent • Interest rate = 10 percent What is the value of a warrant? Solution: l (S/E) + (r + σ2 /2) t d1 = = = = = = = σ√t ln (70 / 40) + [0.9713-0.20) = 1.9678 + 0.1500)(0.8849 – 0.4333 = 20.2993 d2 . we get N(1.9713 By linear extrapolation.93 x 0.6 1.8749 + (1. we get N(1.9678 + (1.1737) From the tables we have N(1.3(4)1/2 0.9690 – 20. N(d2) = 60 x 0.8749)/0.1737) = 0.8500)(0.0.9678 and N(1.9690 N(d2) = N(1. Vishal Enterprises has just issued warrants.1151 = 0.73 Value of the warrant is Rs.8796= 39.8993 d1 .15) = 1.1737 – 1.5596 + 0.90)= 1.00474 = 0. e-rt.93 C = So N(d1) – E.3)2/2]4 0.05 = 0.8796 E/ert = 30/1.8993 – 0.8665 – 1.8849 By linear extrapolation.73.05 = 0.9678)/0.85)= 1.1251 = 0. 39.0. 2.10 + (0.σ √ t 1.

9032 E/ert = 40/1. e-rt.57 Total= 632. Shivalik Combines issues a partly convertible debenture for Rs 900.90)= 1. 3. carrying an interest rate of 12 percent. of shares after conversion in one year = 2 Value of the shares at the price of Rs.0.0287= 0. (a) What is the value of convertible debenture? Assume that the investors’ required rate of return on the debt component and the equity component are 12 percent and 16 percent respectively.81 x 0. Rs 300 will get compulsorily converted into two equity shares of Shivalik Combines a year from now.26 .30) From the tables we have N(1.78 Value of the warrant is Rs. 5 and 6 respectively.82 Payments that would be received from the debenture portion: Year 1 2 3 4 5 6 Payments PVIF12%.712 51.26 272 0. which is very nearly equal to N(1.344. The nonconvertible portion will be redeemed in three equal installments of Rs 200 each at the end of years 4.38 72 0. which is very nearly equal to N(1. The tax rate for Shivalik is 35 percent and the net price per share Shivalik would realise for the equity after a year would be Rs 180. What is the post-tax cost of the convertible debenture to Shivalik ? (b) Solution: (a) No.9713 N(d2) = N(1. N(d2) = 70 x 0.893 96.78.30) = 1.62 224 0.8993) .N(d1) = N (1.0968 = 0. The expected price per share of Shivalik Combines’s equity a year from now would be Rs 200.90) From the tables we have N(1.636 172.567 140. 43.400 PV of the convertible portion at the required rate of 16% = 400/1.16 = Rs.2993).200 = 2 x 200 = Rs.0.t PV 108 0.44 72 0.99 248 0.4918 = 26.9032= 43.9713 – 26.507 113.797 57.81 C = So N(d1) – E.

25 which is very near to zero. carrying an interest rate of 10 percent. Let us try a discount rate of 10 %. The non-convertible portion will be redeemed in four equal installments of Rs 160 each at the end of years 3. 977.18 = Rs. The tax rate for Brilliant is 33 percent and the net price per share Brilliant would realise for the equity after a year would be Rs 220. Brilliant Limited issues a partly convertible debenture for 1000.47 Payments that would be received from the debenture portion: .1)6 = 0.35) 900 -430 -47 -47 -247 -232 -216 The post-tax cost of the convertible debenture to Shivalik is the IRR of the above cash flow stream.82 + 632.08 (b) The cash flow for Shivalik is worked out as under: Year 0 1 2 3 4 5 6 Cash flow =-360-108*(1-0.35) =-200-48*(1-0. (b) What is the post-tax cost of the convertible debenture to Brilliant? Solution: (a) No.1)2 .1)3 -247/(1.26 = Rs. (a) What is the value of convertible debenture? Assume that the investors’ required rate of return on the debt component and the equity component are 13 percent and 18 percent respectively.300 = 2 x 300 = Rs.1)5-216/(1. The expected price per share of Brilliant Limited’s equity a year from now would be Rs 300. So the post –tax cost of the convertible debenture to Shivalik is 10% 4.35) =-200-72*(1-0.508. The PV of the cash flow will then be = 900 – 430/(1.35) =-72*(1-0.35) =-72*(1-0.1)4-232/(1. 4. 360 will get compulsorily converted into two equity shares of Brilliant Limited a year from now.47/(1.Value of the convertible debenture = 344.600 PV of the convertible portion at the required rate of 18% = 600/1. of shares after conversion in one year = 2 Value of the shares at the price of Rs.35) =-200-24*(1-0. 5 and 6 respectively.1) -47/(1.

88/(1.05)5-170.783 50.47 + 610.72/(1.23 208 0.88/(1.72/(1.17 Trying a discount rate of 5 %.8/(1.16/(1.66) = 4.66 By extrapolation.04)3 -192.04) -42.4/(1.5 64 0.04)5-170.33) =-64*(1-0.72 The post-tax cost of the convertible debenture to Brilliant is the IRR of the above cash flow stream.t PV 100 0.11 224 0.50 192 0.80 -42.88/(1.54 % So the post –tax cost of the convertible debenture to Brilliant is 4.Year 1 2 3 4 5 6 Payments PVIF13%.08 Value of the convertible debenture = 508.05)3 -192. The PV of the cash flow will then be = 1000 – 361.05)2 – 202.04)2 – 202.04)6 = -16.16 -181.4 -170.33) =-160-48*(1-0.04)4181.26 176 0.17/(16.88 -192.05)6 = 13.33) =-160-64*(1-0.480 84.613 127.33) =-160-32*(1-0.885 88. Let us try a discount rate of 4 %.8/ (1.88 -202.4/(1.543 104.55 (b) The cash flow for Brilliant is worked out as under: Year 0 1 2 3 4 5 6 Cash flow =-440-100*(1-0.54 % .16/(1.33) 1000 -361. 1118.05) -42.17 + 13. The PV of the cash flow will then be = 1000 – 361.08 = Rs.05)4181.48 Total= 610. we have the IRR = 4 + 16.33) =-160-16*(1-0.88/(1.693 155.

Profit and Loss Account Data Balance Sheet Data Beginning of 20X6 End of 20X6 Sales Cost of goods sold 6000 4000 Inventory Accounts receivable Accounts payable 800 500 290 820 490 205 What is the duration of the cash cycle? Solution: (800 + 820) / 2 Inventory Period = 4000 / 365 (500 + 490) / 2 Accounts receivable = period = 30.44 days = 22.11 6000 / 365 (290 + 205) / 2 Accounts payable = 4000 / 365 Cash cycle = 81. The following information is available for ABC Limited.58 = 73. The following information is available for NCEP Limited.CHAPTER 26 1.91 2. Profit and Loss Account Data Balance Sheet Data Beginning of 20X5 End of 20X5 Sales Cost of goods sold 3000 1800 Inventory Accounts receivable Accounts payable 300 180 85 310 170 95 What is the duration of the cash cycle? .

000 640.000 1. It keeps one month's stock each of raw materials and finished goods.800.000 4.200.000 . paid quarterly in advance Rs.900.300.30 18.000 Manufacturing expenses 2.000. 6. paid as incurred Sales promotion expenses. The following annual figures relate to Sugarcolt Limited.600.000 4. Ignore work-in-process.000 4.000 1.000 200.000 x 12) 3. work out the working capital requirements of the company on cash cost basis.9 days = = = 61.000 1.000 2.000 220. Sales (at two months' credit) Materials consumed (suppliers extend two months credit) Wages paid (monthly in arrear) Manufacturing expenses outstanding at the end of the year (Cash expenses are paid one month in arrear) Total administrative expenses.580.000 Wages 1.000 1.680.000 The company sells its products on gross profit of 20 percent counting depreciation as part of the cost of production. Total cash cost Total manufacturing cost Less: Depreciation Cash manufacturing cost Add: Administration and sales promotion expenses Rs.000 140. Cash manufacturing expenses (140.000 5. 6.25 3.600. and a cash balance of Rs. Depreciation : (1) – (2) 4.300.220. Assuming a 25 % safety margin.Solution: Inventory Period Accounts receivable period Accounts payable Cash Cycle = = = = (300+310) / 2 1800/365 (180 + 170)/2 3000/365 (85 + 95) / 2 1800/365 64.000 440. Sales Less : Gross profit (20 per cent) Total manufacturing cost Less : Materials 1.900.87 21.200.000 1. Solution: 1.000 220.000.000.800.

000.333 515.000 4.580.120. Rs. Total cash cost Debtors 12 Material cost Raw material stock Finished goods stock Prepaid sales promotion expenses Cash balance x 1 12 Cash manufacturing cost = x 2 = 5.000 x 12 4.000 B : Current Liabilities Rs.600.000 x 12 1.400.000 Sales (at three months' credit) Materials consumed (suppliers extend one months credit) Wages paid (monthly in arrear) Manufacturing expenses outstanding at the end of the year .A : Current Assets Rs.220.000 50.000 280.600.000 108.333 2= 870.000 1.635.000 12 Sales promotion expenses 12 A predetermined amount A : Current Assets = 1. 8. Material cost Sundry creditors 12 Manufacturing expenses outstanding Wages outstanding x 2= 1.600.000 x 12 = = 140.000.000 1.000 x3= x 3= 12 = 200.000 1= 381.667 One month’s cash manufacturing expenses One month’s wages B : Current liabilities Working capital (A – B) Add 25 % safety margin Working capital required 1.000 2.000 100.000 2 = 266.000 x1= x 12 200.667 1= 133. The following annual figures relate to Universal Limited.

000 Manufacturing expenses Rs.300. Assuming a 20 % safety margin.200.000 x 12 2.600.000.000 x2= x 12 2= 800.800.000 4.000 800. Ignore work-in-process. Solution: 1.000 12 .000.325.000. Total cash cost Debtors 12 Material cost Raw material stock Finished goods stock x 2 12 Cash manufacturing cost = x 3 = 5.(Cash expenses are paid one month in arrear) Total administrative expenses.600. and a cash balance of Rs. Cash manufacturing expenses (100.000 Wages 1.333 3= 1.000 2.000 1. It keeps two months’ stock each of raw materials and finished goods.000 5.600.000 2.300.000.000 5.000.800. paid quarterly in arrears 500.000 400.000 800.000 2. paid as incurred Sales promotion expenses.600.000 3. 8.000 x 12 4.000 x 12) 3.400.000 500.000 5.000 The company sells its products on gross profit of 30 percent counting depreciation as part of the cost of production.000 2= 333. Sales Less : Gross profit (30 per cent) Total manufacturing cost Less : Materials 2.300. Depreciation : (1) – (2) 5. work out the working capital requirements of the company on cash cost basis. Total cash cost Total manufacturing cost Less: Depreciation Cash manufacturing cost Add: Administration expenses A : Current Assets Rs.

Cash balance A predetermined amount A : Current Assets B : Current Liabilities = = 300. for Sharmilee Exports.333 451. Rs. Rs. d.8. Outstanding on account of purchases in December last are Rs.15.12. January through March.000 1. Sales are expected to be: Rs.000 x 12 = = = 100. You have been asked to prepare a cash budget for the next quarter.000 ------------500.710.000 in January.260. The rent per month is Rs.000 in January.350. however. b.000.000 in February. is Rs.000.000 in March.000 in February.000 in March. The estimated purchases are: Rs.000 in February.000 on cash payment in March. e. Payments for purchases will be made after a lag of one month. Salaries and other expenses.667 One month’s cash manufacturing expenses One month’s wages Three months’ expenses B : Current liabilities Working capital (A – B) Add 20 % safety margin Working capital required CHAPTER 27 2. f. They have provided you with the following information: a.000. and Rs. Their target cash balance.758. All sales will be in cash.220.333 Rs.000 and the partners’ personal withdrawal per month is Rs.15.000 in January. Material cost Sundry creditors 12 Manufacturing expenses outstanding Wages outstanding Sales Promotion expenses x 1= 2.12.300.20. and Rs.667 2.000 1 = 166. payable in cash.000 in March. are expected to be: Rs. c.000 2.16.000. The cash balance at present is Rs. and Rs.000 133. What will be surplus/ deficit of cash in relation to their target cash balance? Solution: .210. They plan to buy two computers worth Rs.50.250.333 100.258. Rs.000.240.

3) 5.000 240.000) 40. You have been asked to prepare a cash budget for the next quarter.000 20. Net cash flow (2 . Inflows 3.000.000 96. Month December (Rs. Minimum cash balance required 8.000 210.000 20.000 in February.000 15.000 16.000 350.000 20. Outflows 4.The projected cash inflows and outflows for the quarter.000 245.000 2.000 8. Rs360.000 ( 15. Rs. January through March.350.000 in January. .000 12. for Jahanara Fashions.450. The estimated purchases are: Rs. Outstanding on account of purchases in December last are Rs.000. b.600.) January (Rs. All sales will be in cash.000 260.12. Surplus/(Deficit) 12.000 55. Opening balance + Cumulative net cash flow 7.) March (Rs.000 240. They have provided you with the following information: a.000 Given an opening cash balance of Rs. Opening balance 2.000 50.) February (Rs.000 350.000 275.400. and Rs.000 245.000 260.000 12.000 and a target cash balance of Rs.000 67.20. Sales are expected to be: Rs.000 in February.000 84.000 47.000 8.000 15.000 275. is shown below .000 306.000 in January. January through March.) Inflows : Sales collection Outflows : Purchases Payment to sundry creditors Rent Drawings Salaries & other expenses Purchase of computers Total outflows(2to6) 300.000 44.000 220.000 32.) March (Rs.000 52. Payments for purchases will be made after a lag of one month. and Rs. Cumulative net cash flow 6.000 220.) February (Rs.) 1.000 210.000 76.380.000 250. the surplus/deficit in relation to the target cash balance is worked out below : January (Rs.000 8.400.000 306.000 300.000 in March.000 in March.000 55.000 12.

000 175.) (Rs.3) 5. Net cash flow (2 .c.30.) January (Rs.40.000 425. Minimum cash balance required 8.000 and the partners’ personal withdrawal per month is Rs.000 in January.000 10.) (Rs.) Inflows : Sales collection Outflows : Purchases Payment to sundry creditors Rent Drawings Salaries & other expenses Purchase of furniture Total outflows (2to6) 400. the surplus/deficit in relation to the target cash balance is worked out below : January February March (Rs.15.000 400. The cash balance at present is Rs. f. What will be surplus/ deficit of cash in relation to their target cash balance? Solution: The projected cash inflows and outflows for the quarter.000 96. Their target cash balance.000 Given an opening cash balance of Rs. Opening balance + Cumulative net cash flow 7.000 10. Surplus/(Deficit) 6. The rent per month is Rs. is Rs.000 425. payable in cash.000 450.000 (50. Cumulative net cash flow 6.) February (Rs. Month December (Rs.000 360. Inflows 3.000 10.000.000) (79.000 350.000 380.000 360.000 450.000 40.10.000) 600.000 (94.6.) March (Rs.000 25.000 400.000 20.6.) 1.000 380.000. is shown below . however.000) ( 85.000) (50.000 ( 59.000 81.000.25.000 on cash payment in January. They plan to buy furniture worth Rs.20.000 600. Opening balance 2.000 . e. are expected to be: Rs..000 and a target cash balance of Rs. Outflows 4.000 350.000 15.000 435.000) (44.000 450.000 30.000 (35.000 435.000) 15.25.15. Rs.000 25.000) 15. January through March.000 25.000 90. d.000 in March.000.000) 400.000 25. Salaries and other expenses.000 in February. and Rs.

000 80.000.000 10.000 160. Smartlink Corporation issues cheques of Rs.10.000 10. What will be the balance in the steady state situation? Solution: The balances in the books of Smartlink Corporation and the books of the bank are shown below: (Rs) 1 2 3 4 5 6 7 8 Books of Smartlink Corporation: Opening Balance Add: Cheque received Less: Cheque issued Closing Balance Books of the Bank: Opening Balance Add: Cheques realised Less: Cheques debited Closing Balance 80.000 110.60.000 140.000 to begin with.000 10.000 80.000 160.000.000 180.000 80. 4.000 200.80.000 30.000 daily and it takes 3 days for these cheques to be realised.000 140.000 120.000 120.000 10. Shahanshah Limited receives cheques of Rs.000 80.100.000 30.000 30.000 10.000 180.000 30.000 80.000 100.000 110.000 140.000 200.30.000 30.000 10.000 220. Hence in the steady situation Smartlink Corporation has a negative net float of Rs.000 From day 7 we find that the balance as per the bank’s books is less than the balance as per Smartlink Corporation’s books by a constant sum of Rs. Assume that there is a balance of Rs.000 10000 160. show the balance in the book of the firm and the books of the bank.000 100.000 daily and it takes 5 days for its cheques to be cleared. show the balance in the book of the firm and the books of the bank.000 30.000 10.000 180.000 10.000 daily and it takes 6 days for its cheques to be cleared.000 30.60.80. Assume that there is a balance of Rs.50.000 to begin with.000 160.000 30.000 30.000 240.000 140.3.000 220.000 30. Smartlink Corporation receives cheques of Rs. Shahanshah Limited issues cheques of Rs.000 30.000 30.000 10.000 80.000 80.000 daily and it takes 4 days for these cheques to be realised.000 80.000 80. What will be the balance in the steady state situation? Solution: The balances in the books of Shahanshah Limited and the books of the bank are shown below: .

000.000 80. Vishal Exports requires Rs.000 50. 5.000 x 150.= Rs.(Rs) Books of Shahanshah Limited Opening Balance Add: Cheque received Less: Cheque issued Closing Balance 100.000 50.000 80.000 260.000 80. The cash payments will be made evenly over the three months planning period.000 --------------------------------. Vishal Exports currently has the amount in the form of marketable securities. The cash payments will be made evenly over the two months planning period.000 80. Vishal Exports earns 8 percent annual yield on its marketable securities.90 million in cash for meeting its transaction needs over the next three months.000 220. What is the optimal conversion size as per Baumol model? Solution: T= 150. The conversion of marketable securities into cash entails a fixed cost of Rs.000 C= = 2 x 6.000 80.000 190.000.000 80.000 320. The conversion of marketable securities into cash entails a fixed cost of Rs.000 100. its planning horizon for liquidity decisions. It currently has the amount in the form of marketable securities that earn 9 percent annual yield.015 According to the Baumol model: 2bt ----I b = 6.000 80. Sourav International requires Rs.000 Books of the Bank: Opening Balance Add: Cheques realised Less: Cheques debited Closing Balance 100.000 per transaction.000 190.000 160. 6.000 50. What is the optimal conversion size as per the Baumol model ? .954.000 280.000 180. its planning horizon for liquidity decisions.000 80.000 I = 0.000 160.000 100. 150 million in cash for meeting its transaction needs over the next two months.000. 10.000 50. Hence in the steady situation Shahanshah Limited has a positive net float of Rs.000 310.000 50.000 280.000 100.10.000 250.000.10.000 290.000 80.000 80.000 130.000 100.4.000 250.000 290.000 80.000 50.451 0.000 260.000 100.000 100.000 180.000 From day 6 we find that the balance as per the bank’s books is more than the balance as per Shahanshah Limited’s books by a constant sum of Rs.015 6.000 50.000 50.500 per transaction.000 220.000 50.09/6 = 0.000 130.

What is the optimal conversion size as per the Baumol model ? Solution: T = 45. Topnotch earns 6 percent annual yield on its marketable securities.2.03 2 x 1500 x 45.02 c = = Rs.000. The cash payments will be made evenly over the six month planning period.06 = 0.500 per transaction.000.500.03 2 b = 1.1. its planning horizon for liquidity decisions.03 7.800 • The standard deviation of the change in daily cash balance = Rs.2.08/4 = 0.320 = 0.000.19.000.121. Topnotch Corporation requires Rs.2.500 According to the Baumol model: 2bT C = I = Rs. 6363961.The following information has been gathered.000 = -------------------------------0. • Annual yield on marketable securities = 9 percent • The fixed cost of effecting a marketable securities transaction = Rs.000 What are the ‘return point’ and ‘upper control point’? .02 b = 4.000 I= 0.000 8.000 • Minimum cash balance required to be maintained as per management policy = Rs.45 million in cash for meeting its transaction needs over the next six months.Solution: T = 90.500 According to the Baumol model: 2bT --------I 2 x 4500 x 90. as assumed by the Miller and Orr model .000 I = 0. Ajit Associates expects its cash flows to behave in a random manner. The conversion of marketable securities into cash entails a fixed cost of Rs. Topnotch currently has the amount in the form of marketable securities.

500.08 / 360 = 0.000 What are the ‘return point’ and ‘upper control point’? Solution: I = 0.+ 2.12.644.500.000 = 3 ---------------------------------.226 9. 2.000 • The management wants to maintain a minimum cash balance of Rs.500.661.000 4 x 0.1. 800 • The standard deviation of the change in daily cash balance = Rs.000222 = 3.934.000 x 19. 3. Premier Limited expects its cash flows to behave in a random manner.2 x 3.000222 3 x 1700 x 27. as assumed by the Miller and Orr model.+ LL = 4I 3 x 2.000 x 27.742 UL = 3 RP -2 LL = 3 x 2. Annual yield on marketable securities = 8 percent • The fixed cost of effecting a marketable securities transaction = Rs.00025 RP = = Rs.500. • Annual yield on marketable securities = 5 percent • The fixed cost of effecting a marketable securities transaction = Rs. 2.000 What are the ‘return point’ and ‘upper control point’? .661.000 = Rs.3.27. as assumed by the Miller and Orr model.742 – 2 x 2. Hanson Corporation expects its cash flows to behave in a random manner.000 = Rs.Solution: I = 0.00025 3bσ2 3 ------. 1700 • The standard deviation of the change in daily cash balance = Rs.644.800 x 19.983.500.000 • The management wants to maintain a minimum cash balance of Rs.522 10.174 RP = 3bσ 2 3 -------UI + LL UL = 3RP – 2LL = 3 x 3. The following information has been gathered. The following information has been gathered.500.+ 3.174 .09/360 = 0.000 3 ----------------------------------.000 4 x 0.

756.000139 3bσ2 RP = 3 4I 3 x 800 x 12.000 x 0.Its cost of capital is 12 percent and the ratio of variable costs to sales is 0.000 = 3 4 x 0. Phoenix Limited currently provides 30 days of credit to its customers.000/360) + 0.000 = 1.343 + LL CHAPTER 27 1.70.333. The tax rate for Phoenix is 30 percent. The bad debt proportion on the additional sales would be 6 percent.000139 UL = 3 RP – 2LL = 1.000.80 Rakesh Enterprises are considering extending the credit period to 45 days which is likely to push sales up by Rs. Solution: .60 million.20 .80 x 45 x ( 60.333.000.Solution: I = 0. The bad debt proportion on additional sales would be 15 percent. What will be the effect of lengthening the credit period on the residual income of Phoenix Limited? Assume 360 days to a year.500.150 million. Such an extension is likely to push sales up by Rs. Phoenix is considering extending its credit period to 60 days.000. The tax rate is 33 percent. The firm’s cost of capital is 14 percent and the ratio of variable costs to sales is 0.60.000 x 0. 200 million .15)(0.12 million.12 x 14.000 x 12.05/360 = 0. Its present level of sales is Rs. Rakesh Enterprises currently provides 30 days credit to its customers.585.333 ∆RI = (60. What will be the effect of lengthening the credit period on the residual income of the firm? Solution: ∆RI = [ ∆S(1-V) –∆Sbn](1-t) – k∆I ∆I = (ACPN – ACP0){ S0/360} + V(ACPN) ∆S/360 = (45-30) x (200.000/360) = 14.000.029 + 1. Its present sales are Rs.333 = 290.67) -0.000 2.

What will be the effect of liberalising the cash discount on residual income? . Indus’s tax rate is 30 percent.193.6.000 = 70.20 million.3) 150.250 = 1.000 + 0.000 x 0.75 = 2. Acme Limited provides 30 days of credit to its customers.000 – 0.0. its average collection period is 45 days. its variable costs to sales ratio.25 million.000 . and its cost of capital is 12 percent. net 30.14 (60 – 30) x 360 = 2.70 x 60 x 360 12.30 – 12.000.000 – 1.000.75.000 x 45 x 0.000 x 0.300 million. Such a relaxation is expected to increase sales by Rs.946.12 360 (45-30) + 360 25. The firm’s cost of capital is 12 percent and the ratio of variable costs to sales is 0.000. Its present level of sales is Rs.000.000 – 1. Acme is considering extending its credit period to 45 days. increase the proportion of discount sales to 0.000 3. What will be the effect of lengthening the credit period on the residual income of Acme? Assume 360 days to a year.06] (1 – 0.25 – 25. The present credit terms of Indus Industries are 3/15. and reduce the ACP to 40 days.000.∆Sbn] (1–t) – k (ACPn – ACP0) + x ACPn x V = [25.000. V. The tax rate for Acme is 30 percent.000.750 4.000 x . net 30.470 million.975.000 x 0. The bad debt proportion on the additional sales would be 8 percent. is 0.08] (1 – 0.[12. Its sales are Rs.000.3) 300. Such an extension is likely to push sales up by Rs. is 0. Solution: ∆RI = [∆S (1-V) . The proportion of sales on which customers currently take discount. Indus is considering relaxing its credit terms to 5/15.4.016.85.781.

3. is 22 days.000. its average collection period.460. k.889 = .000.02 = 10.000. The present credit terms of Hitesh Limited are 1/10.3.000 + 20.000 ∆I = (30 – 20) – 0.03 – 0. and its cost of capital.85 x -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- x 40 360 = 4.889 RI 360 = [ 20.000.650 million.000 = 16.250. increase the proportion of discount sales to 0.0. The proportion of sales on which customers currently take discount.12 x 4.055. net 40.000.000] .900.65) + 0.0.9. is 0.15 . its variable costs to sales ratio.000 + 1.556 6. It sales are Rs.000.000 x 0. V.30 [650. It sales are Rs. V.060.800 million.556 – 1.000] . The proportion of sales on .70 + 0.000.75.10 x 16.000 (45 – 40) .000 = 6. Globus’s tax rate is 35 percent.333 5.000 ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 20.000 x 0.t ) + R I S) dn . and its cost of capital is 10 percent. and reduce the ACP to 20 days.556 = 780.556 = 2.000] 0.p0S0do = 0.805. its average collection period is 30 days. Globus is considering relaxing its credit terms to 3/10. net 40. ACP.03 I = 470.6 [470.000 30. net 30.000.000 ] x 0. The present credit terms of Globus Corporation are 2/10. Such a relaxation is expected to increase sales by Rs.5 [650. is 0.05 .000 650.000.000.30 million.685. is 0.000 (0.000.680.638.556 ∆ R I = [30.000 + 30.75 x x 20 360 360 = 18. is 15 percent.000 DIS ] (1 .000.5.300.638.805.000] (0.4 x 470. What will be the effect of liberalising the cash discount on residual income? Solution: ∆ RI = [∆S (1 – V) – ∆DIS] (1 – t) + R ∆ I ∆ DIS = pn (So + ∆S)dn – poso do = 0.200.060.000 – 3.80.Solution: RI DIS = [ S(I–V)= pn (S0 + = 9. its variable costs to sales ratio.300.25) – 6.

(0.10 million to customers in category B and Rs.333 7. and the cost of capital is 16 percent.888.35) -0.889 – 2.000. The present sales of Nachiket Industries are Rs. The firm classifies its customers into 3 credit categories: A.4.50 million.000. The firm extends unlimited credit to customers in category A.∆Sbn](1-t).000] .000 x 0.333 = 3. ACP= 45 days.000.200. the firm is foregoing sales to the extent of Rs.8 x x 18 360 360 = 8.000. is 0. ∆RI = [ 30.470. and C.2) – 7. The contribution margin ratio for the firm is 20 percent.888.000 + 1.80.000 x 45 x 0.02 – 0.000. Hitesh is considering relaxing its credit terms to 2/10.35 Hence.889 = 2.000. t = 0.40 [800.20 million to customers in category C.80). and no credit to customers in category C. limited credit to customers in category B.000 50.6.000. The tax rate for the firm is 35 percent.100 million.000 800.000. What will be the effect of relaxing the credit policy on the residual income of the firm? Solution: ∆ RI = [∆S(1-V).1333.7) + 0. As a result of this credit policy.033. V=0. po. bn =0. k=0.15 x 6. and reduce the ACP to 18 days.30 million. increase the proportion of discount sales to 0. Hitesh’s tax rate is 30 percent.200. The firm is considering the adoption of a more liberal credit policy under which customers in category B would be extended unlimited credit policy and customers in category C would be provided limited credit.000 = 7.10.000 = 6.000] (0.000. Such relaxation would increase the sales by Rs.80 360 = Rs.100.30.16 x 30.889 ∆ R I = [50. What will be the effect of liberalising the cash discount on residual income? Solution: ∆ RI = [∆S (1 – V) – ∆DIS] (1 – t) + R ∆ I ∆ DIS = pn (So + ∆S)dn – poso do = 0.01 = 10.000 ∆I = (22 – 18) – 0.000 . 1.000.000] .000.000.16.30 million on which bad debt losses would be 10 percent.k ∆I ∆S ∆I = x ACP x V 360 ∆ S = Rs.6 [800.888.000 + 50.000(1-0.000. net 30.10 ] (1-0. B. the average collection period is 45 days.which customers currently take discount.000 – 3. Such a relaxation is expected to increase sales by Rs.

What will be the effect of relaxing the collection effort on the residual income of the firm? Solution: ∆ RI = [∆S(1-V).∆BD](1-t) –k∆ I ∆BD=bn(So+∆S) –boSo So ∆I = ∆S (ACPN –ACPo) + 360 360 x ACPN x V So=Rs.000.1million would be extended unlimited credit and other customers limited credit. 2. . The tax rate for the firm is 34 percent. and its bad debt ratio 0.70 million. ACP= 30 days.80 million.70 million.10 million.000 9.75).019. ∆RI = [ 20. increase the average collection period to 30 days. ∆S=Rs. ACPo=20.34 Hence.20. The tax rate of the firm is 35 percent.k ∆I ∆S ∆I = x ACP x V 360 ∆ S = Rs.75 360 = Rs. The firm is considering the adoption of a more liberal credit policy under which customers with annual income in excess of Rs.18 x 20.16.75.8. bo=0. the average collection period is 30 days. its average collection period 20 days.000(1-0.∆Sbn](1-t).000.000 x 0. The contribution margin ratio for the firm is 25 percent.20 million. V=0.60. The present sales of Purvanchal Limited are Rs.08 ] (1-0. V=0.18. Such relaxation would increase the sales by Rs. and raise the bad debts ratio to 0. its variable costs to sales ratio 0.000.20 million on which bad debt losses would be 8 percent. Garibdas Limited is considering relaxing its collection efforts. Presently its sales are Rs.000 x 30 x 0.08.05.34) -0.10 million. its cost of capital 16 percent. t = 0. The relaxation in collection efforts is expected to push sales up by Rs.60. k=0. What will be the effect of relaxing the credit policy on the residual income of the firm? Solution: ∆ RI = [∆S(1-V). and the cost of capital is 18 percent.05.08. bn =0. k=0.

220.0.20. its average collection period 30 days.000. What will be the effect of relaxing the collection effort on the residual income of the firm? Solution: ∆ RI = [∆S(1-V).10.05(Rs.200 million.000)-. ACPN=40 . The relaxation in collection efforts is expected to push sales up by Rs. t = 0.30.05. bn= 0.70. ∆S=Rs.70 and the probability that the customer will default is 0.08(Rs.000(1-.160.000.000.000.70. bn= 0.000 – these figures apply to both the initial and the repeat purchases. ACPo=30. k=0.06 . On the basis of credit evaluation.18. bo=0. its variable costs to sales ratio 0. Sonar Corporation is considering relaxing its collection efforts.∆BD](1-t) –k∆ I ∆BD=bn(So+∆S) –boSo So ∆S ∆I = (ACPN –ACPo) + x ACPN x V 360 360 So=Rs.70.000.200.70) –{.000)](1-0. the probability that he will pay for the repeat purchase will be 0.000.05(Rs.06. the financial manager feels that the probability that the customer will pay is 0.000)-.20 million.05.000 11.08 .000.323.80.20. What is the expected payoff if the credit is granted? .35 ∆RI = [ Rs.ACPN=30 . x x40 x 0. its cost of capital 18 percent.70.70 The financial manager of a firm is wondering whether credit should be granted to a new customer who is expected to make a repeat purchase.33) Rs.20 million.000. Once the customer pays for the first purchase. The tax rate of the firm is 33 percent.16 360 = Rs.000 (40-30) + 360 .000.06(Rs. Presently its sales are Rs.33 ∆RI = [ Rs.000 and the cost of the sale will be Rs. and raise the bad debts ratio to 0.6 10.000 Rs.000 Rs.10. The revenue from the sale will be Rs.60) –{.000(1-.000 (30-20) + 360 .889 x x30 x 0.000.200. V=0.000)](1-0.200 million. increase the average collection period to 40 days.0.18 360 = Rs.596. and its bad debt ratio 0. t = 0.200.35) Rs.90.

The financial manager of a firm is wondering whether credit should be granted to a new customer who is expected to make a repeat purchase.80 x 70.95. On the basis of credit evaluation. the financial manager feels that the probability that the customer will pay is 0.000) – 0.2 x 180.180. the probability that he will pay for the repeat purchase increases to 0.000) .20.95 (70.000 and the cost of the sale will be Rs.000) + 0. What is the expected payoff if the credit is granted? Solution: Expected pay off = = (0.000 13.000 and the cost of the sale would be Rs. Once the customer pays for the first purchase. the probability that he will pay for the repeat purchase will be 0.200.000 – these figures apply to both the initial and the repeat purchases.250. The revenue from the sale will be Rs.000] 66.(0. Once the customer pays for the first purchase.000 – these figures apply to both the initial and the repeat purchase.80 and the probability that the customer will default is 0. On the basis of credit evaluation. The revenue from the sale will be Rs. The financial manager of a firm is wondering whether credit should be granted to a new customer who is expected to make a repeat purchase. What is the expected payoff if the credit is granted? .90.30.70 and the probability that the customer will default is 0.Solution: 12.05 x 180. the financial manager feels that the probability that the customer will pay is 0.160.80 [0.

000. what is the average collection period (ACP) on non-discount sales? Solution: Discount sales Accounts receivable = [ACP on discount sales] 360 Non – discount sales + [ACP on non-discount sales] 80. If the accounts receivable average Rs.200 million.25 million. 40 percent of its customers pay on the 10th day and take the discount. If accounts receivable average is Rs.000 = [10] 360 S0 ACP = 38. what is the average collection period (ACP) on non discount sales? + ACP 360 360 120. 2/10. net 60 . Annual sales are Rs.200 million. ATP Ltd.000.000. net 30. 40 percent of its customers pay on the 45th day and take the discount.000 .15 million.Solution: 14.Annual sales are Rs.3 days 15. Zenith Enterprises sells on terms. sells on terms 4/45.000 15.

40 days after their purchases.000 15.4 x 200 0.3 days 17. Total sales for the year are Rs. 2/10. on average. 40 percent of its customers pay on the 10th day and take the discount.e. Forty percent of the sales amount is paid on the tenth day (availing the discount) and the remaining 60 percent pay.000. Zenith Enterprises sells on terms.60 million.000. If accounts receivable average is Rs.000 + ACP 360 360 Solving the above we get ACP = 38. net 30.000. . net 30.200 million. Calculate the average collection period and the average investment in receivables.15 million. what is the average collection period (ACP) on non-discount sales ? Solution: Discount sales Accounts receivable = [ACP on discount sales] 360 Non – discount sales + [ACP on non-discount sales] 80.+ ACPND x ----------------360 360 i.6 x 200 25 = 45 x ------------------.Solution: Accounts receivable Discount sales = [ ACP on discount sales][ --------------------] 360 Non-discount sales +[ACP on non-discount sales][ --------------------------] 360 0. 25x 360 = 3600 + ACPND x 120 ACPND = 45 16.000 = [10] 360 120. Malwa Industries sells on terms 3/10. Annual sales are Rs.

4.4 x 10 + 0.Solution: 40% of sales will be collected on the 10th day 60% of sales will be collected on the 40th day ACP = 0.000 Loss when the customer does not pay = Rs.100 million.14.000.000 .000. Solution: 20% of sales will be collected on the 15th day 80% of sales will be collected on the 60th day ACP = 0. the investment in receivables is : Rs.000 –(1-p1)36.36.36.50. A firm is wondering whether to sell goods to a customer on credit or not.000 Value of receivables = 360 = Rs.000 and the cost of sale will be Rs.14.000 = Rs.667 x V 18.60. 60 days after their purchases.666.100. net 40. on average.6 x 40 = 28 days Rs.000 Expected profit = p1 x 14.8 x 60 = 51 days Rs.Rs. in order to sell profitably? Solution: Profit when the customer pays = Rs.000.000 x 51 360 Value of receivables = = Rs.667 Assuming that V is the proportion of variable costs to sales.36. x 28 Calculate the average collection period and the average investment in receivables. Twenty percent of the sales amount is paid on the fifteenth day (getting the benefit of discount) and the remaining 80 percent pay.2 x 15 + 0.166.000 .666.166. Total sales for the year are Rs. 14. the investment in receivables is : Rs.50.667 Assuming that V is the proportion of variable costs to sales. What should be the minimum probability that the customer will pay.667x V 19.4. Bheema Enterprises sells on terms 4/15. The revenues from sale will be Rs.

000 = 0 p1 = 0.000 – (1.000 –(1-p1)80. of Order Orders Per Quantity Year (Q) (U/Q) Units Ordering Cost (U/Q x F) Rs.80. and ten orders per year? (b) What is the economic order quantity? Solution: a.000 Expected profit = p1 x 20.000.p1)36.000 numbers of this machine tool annually at a price of Rs.10) Rs.100.100.000 60.000 and the cost of sale will be Rs.000 150.65.Setting expected profit equal to zero and solving for p1 gives: p1 x 14. A firm is wondering whether to sell goods to a customer on credit or not.000 – (1. 1 2 5 10 60.80.000 .000 30.000 = Rs. The revenues from sale will be Rs. Economic Order Quantity (EOQ) = PC = 980 units (approx) .72 20.000 80 160 400 800 2 UF 300.8 CHAPTER 29 Solution: 1.400 30. in order to sell profitably? Profit when the customer pays = Rs.000 6. two. five.80 per piece.p1)80. No. (a) What is the total cost associated with placing one.800 2x60.000 300.000 12.000 Loss when the customer does not pay = Rs.000x 80 = 10 b. The firm sells 60.80. What should be the minimum probability that the customer will pay.160 60.72 Hence the minimum probability that the customer must pay is 0.080 150. Rs.000 = 0 p1 = 0.000 Setting expected profit equal to zero and solving for p1 gives : p1 x 20. however.10 per year and the cost of placing an order is Rs.80.20. The cost of carrying a machine tool is Rs. Pioneer Stores is trying to determine the economic order quantity for a certain type of machine tool. Rs.Rs. The purchase price per machine tool to the firm is.000 30. Carrying Cost Total Cost Q/2xPxC of Ordering (where and Carrying PxC=Rs.8 Hence the minimum probability that the customer must pay is 0.

60 x 0.000 1. and ten orders per year? (b) What is the economic order quantity? Solution: a. if the size is equal to the EOQ? (c) What will be the total cost of carrying and ordering inventories when 10 orders are placed per year? Solution: 2UF a EOQ = PC U=25. National Stores is trying to determine the economic order quantity for certain type of transformers.60. the carrying cost per year is 30 percent of the inventory value. eight .18 .400.2. (b) How many times per year will inventory be ordered. The firm sells 400 numbers of this transformers annually at a price of Rs. Rs.300 per piece. four.30 =Rs.440 2. The purchase price per unit is Rs.40 per year and the cost of placing an order is Rs. The purchase price per machine tool to the firm is.230.720 2. No.000 . F=Rs. of Order Orders Per Quantity Year (Q) (U/Q) Units Ordering Cost (U/Q x F) Rs.000 2. The cost of carrying a transformer is Rs. Rs. PC= Rs. however.400.40) Rs. (a) What is the total cost associated with placing one.180. 1 4 8 10 400 100 50 40 180 720 1440 1800 8. (a) Determine the economic order quantity. Harilal Company requires 25.000 units of a certain item per year. and the fixed cost per order is Rs. Carrying Cost Total Cost Q/2xPxC of Ordering (where and Carrying PxC=Rs.600 2 UF b.000 800 8.180 2. Economic Order Quantity (EOQ) = PC 2x 400x 180 = 40 = 60 units 3.

000 b. the number of orders relevant for the year will be 23. Number of orders that will be placed is a EOQ = PC U=50. the number of orders relevant for the year will be 27. Hence the ordering cost for the present year will be 23. The purchase price per unit is Rs.2 x 25.400 = Rs. (b) How many times per year will inventory be ordered.000 x 400 EOQ = = 1054 units.000 . Number of orders that will be placed is = 27.20 x 0. if the size is equal to the EOQ? (c) What will be the total cost of carrying and ordering inventories when 10 orders are placed per year? Solution: 2UF b.38 x Rs.(approximately) 3 50.15 =Rs. PC= Rs. the 28th order will serve partly(to the extent of 38 percent) the present year and partly(to the extent of 62 per cent) the following year.72 1. In practice 24 orders will be placed during the year. So only 38 per cent of the ordering cost of the 28th order relates to the present year. the carrying cost per year is 15 percent of the inventory value. (a) Determine the economic order quantity.100. Kamal and Company requires 50.054 Note that though fractional orders cannot be placed. Hence the ordering cost for the present year will be 27.100.38 .000 = 23.20.974 2 4.100 = Rs. and the fixed cost per order is Rs.000 x 100 EOQ = = 1826 units. Total cost of carrying and ordering inventories 1054 = [ 23.38 1.72 . F=Rs. However. 18 25. In practice 28 orders will be placed during the year. Total cost of carrying and ordering inventories . However.18.000 units of a certain item per year.2.488 c.738 c. the 24th order will serve partly(to the extent of 72 percent) the present year and partly(to the extent of 28 per cent) the following year. So only 72 per cent of the ordering cost of the 24th order relates to the present year.3 2 x 50.9.72 x Rs.826 Note that though fractional orders cannot be placed.72 x 400 + x 18 ] = Rs.

149 6.200 .000 units.200 Purchase price per unit = Rs.10 per unit is offered if the order size is 3.25 2 - 316 x 160 x 0.000 2.360 Carrying cost = 35 percent of inventory value What is the economic order quantity? Now.000.000 + 5329 – 32. F=Rs. Should Jaibharat seek the quantity discount? x 3 ] = Rs.40 EOQ = 2 x 10.38 x 100 + 2 5.5477 Solution: U=10.. Consider the following data for a certain item purchased by Jaibharat Stores. assume that a discount of Rs.000 = 10.1826 = [ 27. PC =Rs.000 (154)0.180 = Rs. Consider the following data for a certain item purchased by Liberty Stores.6 per unit is offered if the order size is 2.000 x 200 2.160 x 0.000 units Fixed cost per order = Rs.25 2 = 60. Annual usage = 10.160 Carrying cost = 25 percent of inventory value What is the economic order quantity? Now.000 units Fixed cost per order = Rs.400 Purchase price per unit = Rs.000 x 6 + 316 - 10.000 x 200 = 316 units (approximately) 40 U U Q* Q’ FQ’(P-D)C Q* PC ∆π = UD + 2 2 10.33. Annual usage = 25.000 units.25 =Rs. assume that a discount of Rs. Should Liberty seek the quantity discount? .

PC= Rs. PC =Rs.126 EOQ = 2 x 25.35 2 = 250.35 2 - 399 x 360 x 0.000 = 25.50 = Rs.000 x 10 + 399 - 25.000 (350)0.06 x Rs.000 x 400 = 399 units (approximately) 126 U U Q* Q’ FQ’(P-D)C Q* PC ∆π = UD + 2 2 25.000 What should Shaheed Corporation do? Solution: U=10.35 =Rs.613 = Rs.360 x 0. The supplier offers quantity discount as follows: Order Quantity 2.000 3.Solution: U=25. and the inventory carrying cost is Rs.8 per unit per year.000 + 21.000 units of a certain item annually. The cost per unit is Rs.113.400 .200. Shaheed Corporation requires 10.16 = Rs.8 Discount Percentage 6 8 2 x 10.000.50.50 x 0. F=Rs.729 – 158. F= Rs.000 .200 .3 Change in profit when 2.000 x 400 3.000 3. the fixed cost per order is Rs.000 units are ordered is : EOQ = .000 x 200 = 707 units 8 If 2000 units are ordered the discount is : .116 7.

4 Change in profit when 3.000 ∆π = 15.20 Change in profit when 3.50 = Rs. The supplier offers quantity discount as follows: Order Quantity 3.000 Discount Percentage 4 7 What should Merit International do? Solution: U=15.000 1025 . 33. F= Rs.000 units of a certain item annually.350 .000 10.950 As the change in profit is more when the discount on 3000 units is availed of. the fixed cost per order is Rs.000 +2162– 8.80 x 0.10.3.80 = Rs.000 x 350 3.000 x 4. The cost per unit is Rs.350. that option is the preferred one.000 x 350 EOQ = = 1025 units 10 If 3000 units are ordered the discount is : .000 + 1829.16 2 - = 30.000 5. Merit International requires 15.000 units are ordered is : 10.137 2 If 3000 units are ordered the discount is : .000 707 x 50 x 0.04 x Rs.000 .4692 =Rs. 8.16 2 707x50x0.000 x 200707 3000 3000x46x0.10 2 x 15.212 = Rs.16 2 ∆π = 10.000 x 3. and the inventory carrying cost is Rs.125 = Rs.08 x Rs.16 707 2000 x 47 x 0.10 per unit per year.80.000 ∆π = 10.000 x 200 2.000 x 3 + 10.27.000 units are ordered is : 15. PC= Rs.2 + 15.0 + = 40.

125 2 - 1025 x 80 x 0.947 As the change in profit is more when the discount on 5000 units is availed of.5 .2 . 69.275 =Rs.125 2 2 ∆π = 15.9. Daily usage rate in tonnes 5 7 9 Probability Lead time in days 4 6 10 Probability .5.3) 36 (0. Required: (a) What is the optimal level of safety stock? (b) What is the probability of stockout? Solution: The quantities required for different combinations of daily usage rate(DUR) and lead times(LT) along with their probabilities are given in the following table LT (Days) DUR (Units) 4(0.000 x 5.2 The stockout cost is estimated to be Rs. Gulfstar Corporation requires steel for its fabrication work.5.000 + 3372.5) 28 (0.07 x Rs. The carrying cost is Rs.125 = Rs.125 = 48.6 + = 84.2.3000 x 76.8 x 0.06) 50(0.3) 10(0.42.4 x0.15) 54(0.5 .2) 5(0.15) 70(0.000 x 3501025 5000 5000x 74.000 15. These distributions are independent. 9.25) 42(0.000 per ton per year.097 2 If 5000 units are ordered the discount is : .06) The normal (expected) consumption during the lead time is : .10) 30(0.3 .3 .80 = Rs. The probability distributions of the daily usage rate and the lead time for procurement are given below.09) 90(0.5) 6(0.125 1025x80x0.000 units are ordered is : 15.000 per ton.2) 20*(0.000 +4072– 18.04) 7(0.10) 9(0. that option is the preferred one.6 Change in profit when 5.

000 200.000 240.24 = 42 tonnes .06 16.280 0.24 48.000 14.24 12.10 0.000 12.06 8.09 0.000 0 0.000 10.472 35.000 180.508 14.06 Rs. 0 6.000 0.400 14.10 0.10 0.600 5.800 18.10 0.04 0.04+ 28x0.09 + 90x0.000 140.000 0.15 + 70x0.24 8.200 61.200 141.24 1.000 Rs.76 tonnes a.06 = 41.76 + 0.24 16 36 80.800 1.000 0.24 28.24 8 12 28 48 40.200 0.880 0 0. Costs associated with various levels of safety stock are given below : Safety Stock* Stock outs(in tonnes) 2 Stock out Cost Probability Expected Stock out Carrying Cost Total Cost 1 3 4 5 [3x4] 6 [(1)x2.15 0.928 24.04 0.480 56.000] 7 [5+6] Tonnes 48.648 5.480 62.15 + 54x0.480 Rs.25 + 42x0. 06 + 50x0.24 tonnes Reorder level = Normal consumption during lead time + safety stock K= 41.24 28.928 So the optimal safety stock= 0.200 241.24 4 20 40 20.10 + 30x0. 96.800 1.09 0.400 35.000 100.000 23.10 + 36x0.480 12.20x0.06 480 35.24 0 20 0 100.000 60.400 180 1.800 10.06 0 35.120 14.480 40. 96.09 0.480 43.200 41.280 8.

1.3 The stockout cost is estimated to be Rs.2) 10(0. These distributions are independent.12) 30(0.24 tonnes . 70 or 90 tonnes) Probability (consumption = 50 tonnes) + Probability (consumption = 54 tonnes) + Probability (consumption = 70 tonnes) + Probability (consumption = 90 tonnes) = 0. The carrying cost is Rs.12 + 20x0.06 = 23.24 + 30x0.12) 40(0.3) 2(0.24) 32(0.04 +0.29 10.12) 20(0.04 + 24x0.b.500 per ton per year. Five Star Limited requires steel for its fabrication work. Required: (a) What is the optimal level of safety stock? (b) What is the probability of stockout? Solution: The quantities required for different combinations of daily usage rate(DUR) and lead times(LT) along with their probabilities are given in the following table LT (Days) DUR (Units) 5(0.4 .7.24) 24(0.6 . The probability distributions of the daily usage rate and the lead time for procurement are given below.09+0.4 .12 + 40x0. 24 + 20x0.6) 10(0.1) 8(0.10 + 0.1 .06 = 0.02) 16(0.4) 4(0. Daily usage rate in tonnes 2 3 4 Probability Lead time in days 5 8 10 Probability .012+ 15x0.2 .04 + 16x0. 54.04) 20(0.4) 3(0.000 per ton.04) 15 (0. Probability of stock out at the optimal level of safety stock = Probability (consumption being 50.06) The normal (expected) consumption during the lead time is : 10x0.02 + 32x0.

25.320 61.12 0.30 .720 6.76 8. Probability of stock out at the optimal level of safety stock = Probability (consumption being 30.12 0.000 0.360 Rs.76 16.c.320 0.12.76 2 8 14.76 6 8 16 42.000 0.480 10.06 Rs.620 0 0.500 6.140 19.040 5.000 1.76 5.76 6.352 So the optimal safety stock= 6.12 +0.76 0 8 0 56.140 Rs.24 0.12 0.76 tonnes Reorder level = Normal consumption during lead time + safety stock K= 23.040 6.352 21.680 3.06 1.000 0 0.678 7.12 0.140 15.24 + 6.180 0.000 56.000 56. or 40 tonnes) Probability (consumption = 30 tonnes) + Probability (consumption = 32 tonnes) + Probability (consumption = 40 tonnes) = 0.039 0 21.06 1.06 = 0.320 47. Costs associated with various levels of safety stock are given below : Safety Stock* Stock outs(in tonnes) 2 Stock out Cost Probability Expected Stock out Carrying Cost Total Cost 1 3 4 5 [3x4] 6 [(1)x1.140 16.06 1.277 5. 25.76 = 30 tonnes d.76 8.12+ 0. 0 3.358 7.720 18. 32.12 0.140 13.500] 7 [5+6] Tonnes 16.360 5.320 117.

00 Annual Usage (in Units) Rs.00 200.600 16.00 48.000 48.00 75.000 49.00 100.00 10.00 9 10 11 12 13 14 15 16.200 Price per Unit Rs.00 12.00 800.000 153.00 200.00 120. A.00 16.000 3.00 Required: (a) rank the items of inventory on the basis of annual usage value.00 200.000 400 6.00 12. 18.000 2.00 75.00 40.000 40.00 5.000 192.000 6.00 120. 30. (d) classify the items into three classes.800 1.500 28.000 760.00 16. (c) show the cumulative percentages of usage of items.500 700 3.00 48.000 160.00 10.00 5.800 1.00 800. (b) record the cumulative usage in value.000 400 200 16.00 67.000 400 6.00 .000 24.600 Item Ranking 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 13 15 12 11 9 2 5 14 7 10 1 6 3 8 4 1.000 3.00 40.600 Price per Unit (Rs) Item Annual Usage (Number of Units) Price per Unit (Rs) 1 2 3 4 5 6 7 8 30. B and C Solution: Annual Usage(in Units) 600 30 4.11. Item Annual Usage (Number of Units) 600 30 4. The information about annual usage and price for 12 items used by a firm is as given here.00 100.000 20.00 200.000 12.000 3.00 67.500 700 3.000 2.000 67.200 1.000 400 200 3.000 12.000 450.

99 76.948.032.832.52 94.000 49.40 59.000 450.972.000 20.16 92.02 x 0.000 6.100 1.98 15 360 = 0.42 87.) 760.000 18.00 66.600 67.67 93.100 2.100 1.87 97.05 98.000 28. 0.Cumulative Value of Items & Usage Annual Usage Value (Rs.000 1.49 95. Solution: Annual interest cost is given by .992.100 1.100 1.03 98.67 13.600 1.) 760.98 % .000 192.000 153.4898 = 48.72 90.54 68.Discount % Credit period – Discount period 360 Therefore.600 1.920.000 40.100 2.67 73.100 1.715. What is the annual percentage interest cost associated with the following credit terms? (a) 2/15 net 30 (b) 3/10 net 30 (c) 2/10 net 45 (d) 1/5 net 15 Assume that the firm does not avail of the cash discount but pays on the last day of the net period.67 33.500 48.33 40.000 1.010.00 26.880.026. the annual per cent interest cost for the given credit terms will be as follows: a.33 100 CHAPTER 30 1.000 Cumulative Annual Usage Value(Rs.402.782.00 6.00 46.70 100.000 1.000 16.562.100 Item no.210.000 1.92 99.00 86.87 84.33 60.33 80.000 24.67 53.33 20. Discount % x 1. Rank Cumulative % of Usage Value Cumulative % of Items 11 6 13 15 7 12 9 14 5 10 4 3 1 8 2 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 37.000 160.100 2.

2784 40 360 x = 0.99 3.02 0.01 0.67 % c.12 % = 13.98 d.97 360 = 0.84 % = 20.03 0.1336 55 360 x = 0. Current assets Rs (in million) Raw material 40 Work-in-process 8 Finished goods 25 Other current assets 3 76 Current liabilities Trade creditors Bank borrowing (including Bills Discounted) 30 10 . 0. Solution: a.01 0.99 % = 55.99 2.03 x 0.b. 0.2099 35 360 x = 0.2099 35 360 x = 0.97 c.98 360 = 0.98 d. 0.99 % b.5567 20 360 x = 0. 0.02 0.1212 30 = 12.02 x 0. Consider the data for Kanishka Limited. 0.36 % = 20. 0.3636 10 = 36.36 % = 27. assuming that it is possible to stretch payment 20 days beyond the net period. Calculate the annual percentage interest cost of various terms in problem 1 above. 0.

Current assets Raw material Work-in-process Finished goods Other current assets Rs (in million) 280 58 240 68 646 Current liabilities Trade creditors Bank borrowing (including Bills Discounted) Other current liabilities 160 200 42 402 What is the maximum permissible bank finance for Smartlink Corporation under the three methods suggested by the Tandon Committee? Assume that the core current assets for Smartlink Corporation are Rs.75(76)-44 = Rs.75(76-15)-44 = Rs. . 13 million Method 3 : 0.75 million 4. Solution: The maximum permissible bank finance under the three methods suggested by The Tandon Committee are : Method 1 : 0. Consider the data for Smartlink Corporation.24 million Method 2 : 0.75(CA-CL) = 0.75(CA)-CL = 0.1.75(CA-CCA)-CL = 0.75(76-44) = Rs.100 million.15 million.Other current liabilities 4 44 What is the maximum permissible bank finance for Kanishka Limited under the three methods suggested by the Tandon Committee? Assume that the core current assets for Kanishka Limited are Rs.

7. Among various ideas and techniques presented in that seminar.60 12 7 1. He asked Sudarshan. which is given below.50 13 6 1.20 0. Sudarshan gathered information on 18 accounts.80 15 Bad Accounts Xi Yi Current Earning ratio power (%) Account number 11 12 13 14 15 16 17 1.5 million CHAPTER 31 MINICASE 1 Vikram Thapar.30 17 3 1.20 0. a finance executive in his department who recently graduated from a leading business school.75(646) .90 9 – 6 6 8 4 10 7 . to explore the possibility to using discriminant analysis for credit evaluation in Aman Corporation. the technique of discriminant analysis impressed him.75(CA-CL) = 0.75(646 -402) = Rs. He felt that it could be applied for classifying the credit applicants of Aman Corporation into ‘good’ and ‘bad’ categories.75(CA-CCA)-CL = 0.402 = Rs. Good Accounts Xi Yi Account Earning number Current power (%) ratio 1 1.5 million. A ‘good’ account is an account which pays within the stipulated credit period and a ‘bad’ account is an account which does not pay within the stipulated credit period. Sudarshan suggested that the two ratios that are likely to be most helpful in discriminating between the ‘good’ and ‘bad’ accounts are : (i) current ratio (Current assets / Current liabilities).10 1.402 = Rs. 10 ‘good’ and 8 ‘bad’.75(646 -100).75(CA)-CL = 0. Method 3 : 0.40 14 4 1.10 1.183 million Method 2 : 0.82. and (ii) the earning power (PBIT/Capital employed) Vikram Thapar concurred with Sudarshan’s suggestion. recently attended a seminar conducted by an internationally renowned expert on credit analysis.00 20 5 1.90 1.20 16 2 1.Solution: The maximum permissible bank finance under the three methods suggested by The Tandon Committee are: Method 1 : 0.00 1. CFO of Aman corporation.

0 1.8 0.25 ∑(Xi – X) (Yi –Y) 0 0.3 1.01 0.2 Y = 9.90 -2.05 3.25 0.25 0.0 1.5 0.75 0.1 -0.4 Y1 = 140 =14% 10 50 Y2 = 10 = 5% σx2 = 1.6 σxy = = 0.25 20.10 1.16 0.7 Yi 16 17 14 20 13 12 15 10 15 8 9 -6 6 8 4 10 7 2 6 4 Xi .9 1.5 3.5 -15.09 0.2 1.04 0.25 30.1 0 0.6 1.04 0.0 0.5 2.55 0 0.3 0.25 6.40 10 15 8 18 19 20 1.3 0. Solution: Account Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Xi 1.1 0.4 0.4 0.60 1.5 -2.5 4.0 0.25 30.5 -1.04 0 0.09 0.2 0.6 0.2 -0.25 56.25 2.25 2.25 30.2 1.5 7.5 -3.0 X1 = 10 100 X2 = 10 dx = 0.2 -0.16 0.5 -5.8 1.25 6.2 0 -0.75 1.70 2 6 4 Required: Estimate the discriminant function which best discriminates between the ‘good’ and ‘bad’ applicants.5 -5.25 (Yi – Y)2 42.5 -3.89 19 14.3 .8 9 10 1.45 0.56 = .16 0.5 5.36 0.09 0.5 =701 = 14.20 1.25 30.9 1.1 0 -0.0 -0.X 0 0.5 -0.25 240.5 5.4 1.25 12.00 3.6 14.5 1.2 0.1 -0.5 Yi – Y 6.5 -7.5 (Xi – X)2 0 .25 12.082 19 σy2 = 701 =36.1 0.2 0.3 -0.05 1.75 0.2 0.5 +0.1 1.4 2.4 -0.01 0 0.01 0.0 =1.75 ∑(Xi – X) (Yi-Y ) ∑Xi = 24.25 110.0 ∑Yi = 190 ∑ (Xi –X)2 = 1.4 1.01 0.5 10.1 1.04 0.6 1.25 0.3 -0.25 56.5 -1.4 = 1.56 ∑(Yi –Y)2 X=1.25 12.10 0.768 19 dy = 9% .80 0.

844 = 2. = 0.082 x 36. Somnath and Ravi discussed this issue with the finance team of Apex.756 – 6.082 x 9.σxy 0.dy .89 – 0. 025– 0.768 = 14. The group felt that a linear discriminant function of these two ratios would be helpful in discriminating between the ‘good’ and ‘bad’ accounts. Ravi gathered information on 20 accounts.435 σx2.768 x 0.dx = 3. for a discussion.σxy. In that project Ravi had considered four independent variables.σy2.89 x 0.435 The discriminant function is: Zi = 3.σy2 .σxy.177 .590 a= σx2.768 x 0. Ravi concurred with this view.221Xi + 0.0 – 0.σxy. 10 ‘good’ and 10 ‘bad’ which is given below. Somnath thought that Apex could also use discriminant analysis. A ‘good’ account is an account which pays within the stipulated credit period and a ‘bad’ account is an account which does not pay within the stipulated period.dy 36.4 = 0.082 x 36.σxy.768 b= σx2.4 – 0.177 Yi MINICASE 2 Somnath.221 0. He called Ravi.σxy 7.dx .431 = 2.768 x 9 = 0. who joined the finance department of Apex recently.912 3.768 x 0. Finance Director of Apex Electronics. a product of a premier business school from Australia. The consensus view that emerged during the discussion was that the most appropriate ratios would be (i) ROE (PAT/Net worth) and (ii) Current Ratio (Current Assets / Current Liabilities). to begin with he felt that a discriminant model with two independent variables may be used. Ravi showed Somnath a project on discriminant analysis that he had done as part of his graduate studies in business.89 – 0.σy2 . However. was looking at ways and means of improving credit evaluation of the potential customers of Apex.

2 1.15 3.40 9% 1.15 -2.1575 0.1225 0.15 5.15 2.85 6.8225 1.8225 17.10 1.0375 2.0625 0.5775 -0.50 15% 1.0025 0.85 15.2225 34.2975 0.15 0.0025 0.8225 229.5 1.85 Yi – Y 0.05 0.80 13% 1.3 1.85 0.15 -3.12 251.5225 220.4 1.0025 0.0225 0.1 1.35 -0.2075 -0.2 0.2725 2.90 1.9625 -2.15 4.2225 14.00 1.5 1.7225 37.15 -0.3775 0.60 14% 1.0025 0.2925 9.4225 26.1225 0.0225 0.0625 0.3225 23.15 -4.3225 0.10 1.2275 0.15 -0.15 -14.30 12% 1.5225 3.55 -0.15 -0.40 1.0225 0.93 (Xi – X) (Yi -Y) 2.05 -0.05 (Xi – X)2 66.15 10.1 1.X 8.3025 0.25 0.0225 0.85 1.9225 103.0025 0.0225 0.2 Xi .1 1.7225 14.4 1.Account Number 1 2 3 4 5 6 7 8 9 10 Good Accounts Yi Xi Current ROE ratio 18% 1.85 -0.0025 0.8 1.20 1.2 1.0925 0.20 0.20 11 12 13 14 15 16 17 18 19 20 -5% 8% 9% 6% 11% 5% 10% 7% .5225 9.5075 0.35 -0.10 1.35 197 Y= 25 ∑(Xi-X)2=1068.15 -0.6% 4% Required: Estimate the discriminant function that best discriminates between the ‘good’ and ‘bad’ accounts.15 -0.15 -0.05 -0.4225 0.7275 -0.20 20% 1.1525 -0.85 -5.20 6% 1.6225 0.0225 8.5225 0.0225 0.9 1.0625 0.1 1.0 1.2225 (Yi – Y)2 0.55 .15 -0.10 1.2875 -0.0225 4.8325 -0.0225 0.15 -0.85 -3.50 25% 1.1425 2.3225 2.0025 0. Solution: Account Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Xi 18 15 13 20 12 9 16 14 6 25 -5 8 9 6 11 5 10 7 -6 4 Yi 1.25 -0.1 1.10 16% 1.10 Bad Accounts Account Number Xi ROE Yi Current ratio 1.2 1.0225 0.85 -1.05 0.1 1.05 0.25 0.6 1.85 -15.

4921 19 σy2.σxy 56.9 – 0.9 = 0.4921 x 9.13 = 9.σxyσxy 8.3 Y2 = = 1.24 9.37 10 ∑Y2 = 11.7 1.4921 0.dy 0.9 = 1.8 – 4.55 σx2 = ∑ (X1 – X) 1–n 148 = 14.93 σy2 = 0.55 19 = 56.5079 σx2.0489 dx = X1 – X2 dy = Y1 – Y2 = 14.5079 Discriminant function Z = 0.4921 x 0.62569 = 2.25 20 ∑Y1 = 13.4394 .8 10 ∑X2 = 49 49 X2 = = 4.24 a= = σx2.dy .3 11.0489 x 9.9 = 56.3660 = 2.dx .489 – 0.∑X = 197 197 X= = 9.1459 56.37 – 1.2395 ∑(Y1 – Y) = 0.4921 x 0.σxy.1459Xi + 3.068.93 19 = 0.4921 x 0.13 10 = 1068.9 10 X1 Y1 = 13.σy2 .2395 x 0.2395 x 0.4394Yi = 3.σxy.4921 b= σx2σy2 .7 ∑(X1 – X) = 1.2395 x 0.85 20 ∑X1 = 148 ∑Y = 25 25 Y= = 1.35 σxy = = 0.0489 – 0.dx = 0.24 – 0.35 ∑(X1 – X) (Y1–Y) = 9.σxy.

00 7 0. Good Accounts Earning Quick power ratio Xi Yi 16% 0.00 12 0.80 17 1.90 14 0.60 0.10 10 0.90 15 0. the problem of judging the creditworthiness of the various customers of Impex Limited.90 Required: Estimate the discriminant function which best discriminates between the ‘good’ and the ‘bad’ applicants. A ‘good’ account is an account which pays within the stipulated credit period and a ‘bad’ account is an account which does not pay within the stipulated credit period.80 0.70 13 1.MINICASE 3 Ram Kumar. Ram Kumar concurred with this suggestion.80 Bad Accounts Earning Quick power ratio Account Number Account Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 6% 9 4 -5 2 10 8 7 0. Ram Kumar and Sreedhar felt that the two ratios that are likely to be most helpful in discriminating between the ‘good’ and ‘bad’ accounts are (i) earning power (PBIT/Capital employed) and (ii) quick ratio (Quick assets / Current liabilities). Sreedhar gathered information on 18 accounts.70 0.70 0.80 0. the CFO of Impex Limited.70 20 0. a senior financial analyst in the company.90 15 1. Solution: .60 0.50 0. Sreedhar suggested that discriminant analysis may be used for credit evaluation purposes. was discussing with Sreedhar. 10 ‘good’ and 8 ‘bad’ which is given below.

.025 σy2.80 0.04 0.80 0.70 0.90 0.50 0.3 0.01 0 0.04 0.2 0 1.3 0.1 0 –0.20 0.00 0.6 –0.90 Xi – X 6 10 7 2 4 3 –3 5 0 5 –4 –1 –6 –15 –8 0 –2 –3 Yi – Y –0.80 0.00 0.18 X2 = 8 = 5.4 0.Number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Xi 16% 20 17 12 14 13 7 15 10 15 6 9 4 –5 2 10 8 7 Yi 0.025 – 0.3 1.2 0 –0.70 0.347 0.9% = 0.6 0 1.6 0 0.01 Σ(Y-Y)2 = 0.01 0.70 0.347 Contd.1 –0.09 0.8 σy2 = 17 = 0.4 Xi= 10 Yi= 0.10 0 0.dx – σxy.5 0 0 0.94 x 0.01 0 0.8 – 0.3 Σ(Xi-X) (Yi-Y) = 5.60 0.04 0.42 Σ(Xi-X) (Yi-Y) –0.01 0.dy a= σx2.347 x 0.10 0.9 17 = 0.70 dy = 0.2 –0.1 (Xi – X)2 36 100 49 4 16 9 9 25 0 25 16 1 36 225 64 0 4 9 Σ(Xi-X)2 = 628 σx2 (Yi – Y)2 0.6 Y2 = 8 = 0.1 0 –0.04 0 0.1 0.01 0. σxy 0.4 0 1.9 σxy = ΣXi=180 ΣYi=14.8 628 = 17 = 36.2 0.70 1.025 x 8. σy2 – σxy.01 0.1 –0.90 1.60 0.18 = 36.1% dx = 8.94 1 x 5.88 41 5.2 –0.90 0.01 0 0.80 1.8 139 Xi = 8.347 x 0.42 Yi = 10 10 = 13.1 0.6 –0.4 0.09 0.

σy2 – σxy.9235 – 0.15754 = 0.500 2 50. Profit and Loss Account • • • • • • • • • • Net sales Income from marketable securities Non-operating income Total income Cost of goods sold Selling and administrative expenses Depreciation Interest expenses Total costs and expenses PBT 1 40.500 35.8 = 36.000 30.6494 – 3.0.000 2.196 σx2.200 3.347 x 8. Assume a tax rate of 30 percent for year 2.8031 = 0.4774 Z = aXi + bYi = 0.σxy 36.dy – σxy. The profit and loss account and balance sheet of a company for two years (1 and 2) are given below.8031 = 4.18 – 0.000 2.1204 0.347 x 0.94 x 0.400 25.200 .4774Yi CHAPTER 32 1.000 800 600 41.400 2.22 – 0.06246 a= 0.94 x 0.0536 = 0.000 6.000 1.347 6.196Xi + 4.dx b= σx2.600 42.000 1.025 – 0.000 52.900 5.800 9.000 7.

700 6.800 (ii) Solution: What is the tax on EBIT for year 2? Tax provision from profit and loss account 2700 + Tax shield on interest expense Tax on interest income Tax on non .500 8.000 Solution: Profit before tax + Interest expense Interest income Non – operating income 9200 + 2600 .300 40.700 19.300 .600 6.000 2.800 4.• • • • • • • • • • * Tax provision PAT Dividends Retained earnings Balance Sheet Equity capital Reserves and surplus Debt Fixed assets Investments (marketable securities)* Net current assets All of this represents excess marketable securities (i) What is the EBIT for year 2? 1.500 4.000 1.500 1.000 40.500 7.1000 .1000 9.operating income Tax on EBIT 780 .000 16.000 32.000 14.000 7.000 32.300 2880 .000 20.000 24.000 5.400 2.700 6.000 10.

200 .000 3.000 18.000 4.(iii) What is the FCFF for year 2? Solution: EBIT .6. Profit and Loss Account • • • • • • • Net sales Income from marketable securities Non-operating income Total income Cost of goods sold Selling and administrative expenses Depreciation 1 30.800 1.Net investment + Non – operating cash flow (1000 x 0. Assume a tax rate of 30 percent for year 2.900 2 35.800 21.000 600 400 31.600 2.880 .000 800 36.3300 + 1500 After tax income on excess marketable securities .500 700 1120 (iv) Show the break-up of the financing flow Solution: After tax interest expense + + + Cash dividend Increase in borrowing ∆ Excess marketable securities 1820 + 1800 .800 .Tax on EBIT .2.700 1120 2.000 1. The profit and loss account and balance sheet of a company for two years (1 and 2) are given below.7) 9.

700 25.000 5.000 (i) Solution: What is the EBIT for year 2? Profit before tax + Interest expense Interest income Non – operating income 7400 + 1600 .200 3.000 1.600 29.000 15.400 7.300 .600 1.000 18.400 4.000 15.operating income Tax on EBIT 1900 480 .400 5.000 25.400 1.• • • • • • • • • • • • • * Interest expenses Total costs and expenses PBT Tax provision PAT Dividends Retained earnings Balance Sheet Equity capital Reserves and surplus Debt Fixed assets Investments (marketable securities)* Net current assets All of this represents excess marketable securities 1.000 9.100 5.240 1840 .000 5.500 4.900 5.900 29.500 1.800 7200 (ii) Solution: What is the tax on EBIT for year 2? Tax provision from income statement + Tax shield on interest expense Tax on interest income Tax on non .100 14.500 6.1000 .000 29.400 4.000 5.000 5.200 1.000 25.

2500 + 560 3420 (iv) Show the break-up of the financing flow Solution: Rs.1840 . The profit and loss account and the balance sheet for Magna Corporation for two years (year 1 and year 2) are given below : Profit and Loss Account • • • • 1 2 Net sales Income from marketable securities Non-operating income Total income 16800 420 210 17430 19320 630 420 20370 .Tax on EBIT .700 3420 3.(iii) What is the FCFF for year 2? Solution: EBIT . in million After tax interest expense + + + Cash dividend Reduction in borrowing ∆ Excess marketable securities 1120 + 1400 + 100 + 1500 After tax income on excess marketable securities .Net investment + Non – operating cash flow 7200 .

420 4410 .• • • • • • • • • • Cost of goods sold Selling and administrative expenses Depreciation Interest expenses Total costs and expenses PBT Tax provision PAT Dividend Retained earnings Balance Sheet 9660 2100 1050 1008 13818 3612 1092 2520 1260 1260 1 11340 2310 1260 1176 16086 4284 1344 2940 1680 1260 2 • • • Equity capital Reserves and surplus Debt Fixed assets Investments Net current assets 6300 5040 7560 18900 12600 3780 2520 18900 6300 6300 8820 21420 13650 4200 3570 21420 • • • Assume that the tax rate is 40 percent. (i) What is the EBIT (also called PBIT) for year 2? Solution: PBT + Interest expense .Non-operating income 4284 +1176 .Interest income .630 .

6 -2100.(ii) What is the tax on EBIT for year 2 ? Solution: Tax provision from profit and loss account + Tax shield on interest expense .Tax on interest income .0 252. an investment banking firm.4 . is engaged in valuing MLF Realty.0 1167.Net investment + Non-operating cash flow 3015.6 (iv) What is the FCFF for year 2 ? Solution: NOPLAT .Tax on non-operating income Tax on EBIT 1344 + 470. a firm which specialises in the construction of housing and commercial complexes. MLF is currently riding a construction boom and is expected to grow at a healthy .Tax on EBIT 4410 .4 3015. Boldman Sachs.252 .4 (iii) What is the NOPLAT for year 2 ? Solution: EBIT .6 4.168 1394.1394.

EBIT and capital expenditure = Working capital as a percentage of revenues = Cost of debt( pre-tax) = Debt – equity ratio = Risk. Inputs for the Stable Growth Period ---------------------------------------------Growth rate in revenues.0 7. Thereafter the growth rate is expected to decline rather gradually for a few years before it stabilises at a modest level You have recently moved to Boldman Sachs after a few years of experience in another financial services firm. depreciation. Base Year (Year 0) Information -----------------------------------------------Revenues Rs. Working capital as a percentage of revenues = The cost of debt. 350 crore Depreciation and amortisation Rs.free rate = Market risk premium = Equity beta = Inputs for the Transition Period ----------------------------------------• • Length of the transition period = Growth rate in revenues.4 percent 6 percent 1. Based on extensive discussion with management and industry experts you have gathered the following information. 280 crore Capital expenditure Rs. market risk premium and equity beta will be the same as in the high growth period.rate for the next four years at least. capital expenditure and depreciation = Working capital as a percentage of revenues = 3 years • • • • • • • • • • • • • • 4 years 25 percent 20 percent 10 percent 1. 1400 crore EBIT ( 20 % of revenues) Rs.2667 • • 20 percent • • 10 percent 20 percent . EBIT. 266 crore Working capital as a percentage of revenues 20 percent Tax rate 30 percent (for all time to come) Inputs for the High Growth Period --------------------------------------------Length of the growth period = Growth rate in revenues. Your first assignment at Boldman Sachs is to value MLF. debt-equity ratio. risk –free rate. EBIT and Capital expenditures will decline from 25 percent in year 4 to 10 percent in year 7 in linear increments of 5 percent per year. depreciation.

50 546.332 = 12 % b. risk –free rate and market risk premium will be the same as in the previous stages.31 943.70 ∆ WC FCFF WACC (%) PV 1 2 3 4 5 6 7 25 25 25 25 20 15 10 350 437.83 Terminal Value = FCFF8 352.70 245 306.25 164.22 660. and stable)? What value would you impute to MLF Realty using the DCF method? Solution: a.14 --------------= Rs.01 708.10) = 352.81 CAPEX DEP WC 350 437.11 )7 = Present value of FCFF in the high growth and transit periods = Value of the firm 8497.5 109.50 546.49 1025.88 683. transition. = = 2:3 1.58 135.88 683.39 1179. 9205.88 683.4 + 6 x 1.34 70 87.59 854.60 820.14 FCFF8 = FCFF7 (1.83 --------------.4 254.82 478.02 79.37 136.36 1037.36 1037.30 ) + 0.75 11 11 11 11 11 11 11 63.49 708.50 546.19 985.96 154.12 – 0.5 x 15 = 11 % WACC during the stable period: --------------------------------------re = 7.31 943.322 What is the cost of capital in the three periods( high growth.7 191.15 crores .30 ) + 3/5 x 15.41 779.06 71.51 574.50 415.75 x (1.08 246.53 649.25 382.37 136.5 109. WACC during the high growth and transit periods: -----------------------------------------------------------re = 7.59 820.322 = 15.19 1297.06 205.05 113. Debt-equity ratio Equity beta a.72 123.35 726.39 437.98 90.3 320.63 519.50 / (1.29 896.2667 = 15 % WACC = 0.4 + 6 x 1.05 94.10) = 320.11 105 131.73 136.50 Present value of terminal value = 17641.= -----------WACC – g 0.10 = 17641.00 311.332 % WACC = 2/5 x 10 x ( 1 – 0.30 70 87.• • • The cost of debt.5 x 10 x ( 1 –0. Period Growth Rate % EBIT EBIT (1-t) CAPEX Dep 332.10 283.

10 par) Market value of debt Rs. He has requested you to value the equity of Multisoft and asked his CFO. 300 million Inputs for the High Growth Period • • • • • • • • • Length of the high growth period Growth rate in revenues. Base Year (Year 0) Information • • • • • • • • Revenues EBIT Capital expenditure Depreciation Working capital as a percentage of revenues Corporate tax rate Paid up capital (Rs. Gautam Prabhu. will be in the form of the stock of Multisoft Limited. 140 million 30 percent 15 percent Rs. 500 million Rs. 600 million Rs. 750 million Rs. 2000 million Rs. the company did exceptionally well. EBIT and capital expenditure Working capital as a percentage of revenues Cost of debt (pre-tax) The tax rate will increase to 30 percent in linear increments of 5 percent per year Debt-equity ratio Risk-free rate Market risk premium Equity beta = = = = 3 years 40 percent 30 percent 10 percent = = = = 0. Multisoft Limited was set up about twelve years ago by a product-minded technocrat. Ranjan Kaul. however.5 : 1 7 percent 6 percent 1. the company floundered. The management is quite optimistic about future and believes that its growth is more predictable now. Gautam Prabhu believes that the compensation for the merger. the management of Multisoft emphasised software services. The company recorded a compound annual growth rate of 80 percent during this period. as its product offerings were superceded by the offerings of competitiors.3 .5. The following information has been provided to you. depreciation. Subsequently. thanks to the excellent response received by three of its initial products. This strategy has worked well and the company’s performance improved significantly in the last few years. In the first five years. Recently. to provide you with the information about the current and projected financials of Multisoft. if consummated. the CEO of Multisoft Limited had a very fruitful discussion with the CEO of Matrix Software wherein they explored the possibility of a merger. In response.

1 = 30 percent Required a. d. and depreciation Working capital as a percentage of revenues Debt-equity ratio Cost of debt (pre-tax terms) Risk-free rate Market risk premium Equity beta Tax rate = 10 percent = 30 percent = 0.284 : 1 = 10 percent = 7 percent = 7 percent = 1. and capital expenditures will decline from 40 percent in year 3 to 10 percent in year 8 in linear increments of 6 percent each year Working capital as a percentage of revenues Debt-equity ratio Cost of debt (pre-tax) Risk-free rate Market risk premium Equity beta Tax rate Inputs for the Stable Growth Period = 5 years = 30 percent = 0. (c).5 : 1 = 10 percent = 6 percent = 7 percent = 1. EBIT.Inputs for the Transition Period • • • • • • • • • Length of the transition period Growth rate in revenues.2 = 30 percent • • • • • • • • Growth rate in revenues. . depreciation. and (d) must be in rupees in million upto one decimal point) What is the intrinsic value per share? e. capital expenditure. EBIT. c. What will be the WACC (upto one decimal point) year-wise? What is the present value of the FCF in the high growth period? What is the present value of the FCF in the transition period? What is the present value of the terminal value? (Answers to (b). b.

2 (7) = 14.0 246.4) 29.5 4231.5 5495.8% Cost of debt 10 (1 – 0.4 12.8 3846.3 (6) = 14.9 11.4% 1/3 x 7 = 11.3 2871.2 700 980 1372 1838.284 /1.4 2/3 x 14.5 2/3 x 14.2 11.2 514.8 809.0% Year 0 1 2 3 4 5 6 7 8 9 Growth rate % EBIT 750 Tax rate (%) 15 20 25 30 30 30 30 30 30 30 EBIT (1 –T) Capex 500 Deprn 140 196 274.889 0.563 0.9 3014.2 Stable period Cost of equity WACC 7 + 1.284 x 7 = 13.5 2353.5 325.Solution: (a) WACC High growth period Year Cost of equity 1 7 + 1.630 0.0% Transition period Cost of equity 6 + 1.7 621.7 3529.2 890.3 48.3 316.2 3996.3 + 48.3 551.356 85.0 3330.5 1025.5 1440.4 4396.1 547.8 658.8 + 1/3 x 7.0 4835.9 WACC 10 (1 – 0.6 439.9 3445.4 4029.5 3496.2 2823.402 0.0 = 12.4 2470.6) 46.5 89.7 240 336 470.6 96 60.4 384.450 0.9 11.9 4306.284 x 14.9 (17.9 11.3 3663.6 1930.30) = 7 .3) = 7% Cost of debt 2/3 x 14.503 0.5 4995.9 13.2 (12.121.8 + 1/3 x 7.9 11.7% Cost of debt 10 (1 – 0.7 1128.7 + 0.4 = Rs.4 559.6 ∆ WC FCF WACC % PV Factor PV 40 40 40 34 28 22 16 10 10 1050 1470 2058 2757.3 WC 600 840 1176 1646.3) = 7% 1/1.9 (b) Present value of FCF in the high growth period = 85.3 (6) = 14.8% 2 7 + 1.2 399.705 0.25) = 7.0 6044.0 0.5 = 12.2 – 12.8 + 1/3 x 8 = 12.4 164.1 (7) = 14.2 12.5 840 1102.3 (6) =14.4 2206.5 12.4 + WACC 2/3 x 14.9 803.8% 3 7 + 1.8 326.9 158.8 617.5% 10 (1 – 0.20) = 8% 10 (1 – 0.1 million .791 0.9 932.

He has requested you to value the equity of Telesoft and asked Vijay Rao. Though the company started with a bang.1 + 854. The following information has been provided to you.210.0 + 246. Finance Director. the CEO of Telesoft International had a preliminary dialogue with the CEO of a another company engaged in developing telecommunication software to explore a possible merger. 280 million = Rs.13 – 0. 300 million .7 .(c) PV of FCF in the transition period = 29.402 = Rs. 350 million = Rs.5 + 89.10 par) Market value of debt = Rs. 140 million = 30 percent = 10 percent = Rs. 1200 million = Rs. if consummated.854.7 + 11928.10 (e) Intrinsic value per share Value of firm – Value of debt Number of shares 121. Telesoft International was set up seven years ago to develop telecommunication software. Both the CEOs felt enthusiastic about this. Pankaj Behl believes that the compensation for the merger.4 + 164 .7 million 0.7 million (d) PV of terminal value 890.300 = 60 = Rs. Thanks to recovery in the last 18 months or so and a firm indication of strong growth in the next few years. it entered a turbulent phase because of the shrinkage in the global telecom market in the initial years of this decade.5 + 325. 300 million = Rs.3 = Rs.1 6. Pankaj Behl.11928.2 = x 0. Base Year (Year 0) Information Revenues EBIT Capital expenditure Depreciation Working capital as a percentage of revenues Corporate tax rate Paid up equity capital (Rs. Recently. will be in the form of the stock of Telesoft International. the management of Telesoft International is quite upbeat about the future. Telesoft International to provide you with information about the current and projected financials of Telesoft International.

Inputs for the High Growth Period Length of the high growth period Growth rate in revenues.8:1 = 10 percent (pre-tax) = 8 percent = 6 percent = 1.0 Tax rate = 30 percent a.4 Length of the transition period Growth rate in revenues.5:1.1 = 30 percent Inputs for the Stable Growth Period Growth rate in revenues. EBIT. EBIT and capital expenditure Working capital as a percentage of revenues Cost of debt Tax rate will increase to 30 percent in linear increment of 5 percent Debt-equity ratio Risk-free rate Market risk premium Equity beta Inputs for the Transition Period = 4 years = 30 percent = 30 percent = 10 percent (pre-tax) = 0. b.0 Cost of debt = 10 percent (pre-tax) Risk-free rate = 8 percent Market risk premium = 7 percent Equity beta = 1. year-wise? What is the present value of the FCF in the high growth period? What is the present value of the FCF in the transition period? What is the present value of the terminal value? What is the intrinsic value value per share? . d. EBIT. depreciation. depreciation. capital expenditure and = 10 percent depreciation Working capital as a percentage of revenues = 30 percent Debt-equity ratio = 0. e. c. and capital expenditures will decline from 30 percent in year 4 to 10 percent in year 8 in linear increments of 5 percent each year Working capital as a percentage of revenues Debt-equity ratio Cost of debt Risk-free rate Market risk premium Equity beta Tax rate = 4 years = 30 percent = 0. What will be the WACC.8:1 = 7 percent = 7 percent = 1.

4 x (7) = 16.0 = 12.0 128.2% 11.9% 12.9 = Rs.7 76.1% 12.6 96.15) = 8.20) = 8.8 + (4/9)x8.6% Transition period Cost of debt 10(1-0.450 0.7 + 60.0 + (1/3) x 7.3% 0.884 0.4% 11.7% 12.5% 10 (1 – 0.2% 11.9% (5/9)x16.3% Tax Year Growth EBIT rate EBIT Cap Dep’n WC ∆WC FCF WACC PV PV of % (1-T) Exp rate% % Factor FCF 0 350 10 280 140 360 1 2 3 4 5 6 7 8 9 30 30 30 30 25 20 15 10 10 455 592 769 1000 1250 1499 1724 1897 2087 15 20 25 30 30 30 30 30 30 387 474 577 700 875 1049 1207 1328 1461 364 473 615 800 1000 1200 1379 1517 1669 182 237 308 400 500 600 690 759 835 468 608 791 1028 1285 1542 1774 1951 2146 108 140 183 237 257 257 232 177 195 97 98 87 63 118 192 286 393 432 13.2% 11.404 85.783 0.8% Cost of debt 10 (1 – 0.8 PV of FCF in the high growth period.4 x (7) = 16.5 = 12.500 0. 261.5 38.8% 7 + 1.8% 7 + 1.6 + (4/9) x 7 = 11.1(6) = 14.7% (5/9)x16.7 158.7 + 76.695 0.8 million .8% 7 + 1.3) = 7% WACC (5/9) x 14.30) = 7.0 = 12.618 0.0 (7) = 15.0% Stable period Cost of debt 10 (1-0.Solution: (a) WACC High growth period Year 1 2 3 4 Cost of equity 7 + 1.4 x (7) = 16.7 60.2% Cost of equity 8 + 1.3) = 7.5 + 38.0 = 12.8 + (4/9)x8.8 + (4/9)x7. 85.556 0.0% (b) WACC (2/3) 75.25) = 7.1% (5/9)x16.2% 12.9 65.4% Cost of equity 8 + 1.5 = 13.5% 10 (1 – 0.8 + (4/9)x7.0% WACC (5/9)x16.0% 10 (1 – 0.4 x (7) = 16.

10 ⇒ r = 0.59 .0 + 128.26 So D/E = 0.7 + 158.404 = Rs. whereas the market value of its debt is eight -tenths of its book value.6 7. 52 and 0.449. the analyst has estimated the value of the firm to be Rs.74 x 0.2 million 0.70 million for the following year and an expected growth rate of 10 per cent. The market value of equity is twice its book value.1233 = x x 0.33 % 0.09 ⇒ x = 0. Based on an expected free cash flow of Rs.85 Since the market value of equity is twice its book value and the market value of debt is eight-tenths of its book value.26 = 2. the market value weights of equity and debt are in the proportion: 0.10 (e) Intrinsic value per share Value of firm – Value of debt No.1 + 7588.26 The weight assigned to equity is 0.8 = Rs. done by an investment analyst. However. 266.6 + 96.123 – 0.26 x 2 and 0. You are looking at the valuation of a stable firm. What is the correct value of the firm? Solution: 70 3000 = r – 0.22 + (1-x) x 0. of shares (261.1 million (d) PV of the terminal value 432 x 0. he committed a mistake of using the book values of debt and equity.74 / 0.8 That is 0.3000 million.7588.8 + 449.1233 or 12.2) – 300 = 30 = Rs. Solidaire Limited. You do not know the book value weights employed by him but you know that the firm has a cost of equity of 22 per cent and a post-tax cost of debt of 9 per cent.(c) PV of FCF in the transition period 65.

and the discount rate.000 4. 1149.52 x 0.200 30.43 million .1509 .000 assets 5.11 1. its sales will grow at the rate of 30 percent per year for three years. however.09 = 0.11 0. After three years.09 CHAPTER 33 1. Thereafter. The margins. sales will remain constant. capital expenditure will be equal to depreciation.1509 or 15. general. and administrative expenses will be 8% of sales • Depreciation charges will be equal to new investments • The asset turnover ratios will remain constant • The discount rate will be 14 percent • The income tax rate will be 30 percent If Infotex Limited adopts a new strategy. the income tax rate.000 4. The income statement for year 0 (the year which has just ended) and the balance sheet at the end of year 0 for Infotex Limited are as follows.Hence the WACC is 0.000 10..000 6.000 30. Depreciation charges will be equal to 10 percent of the net fixed assets at the beginning of the year.000 Infotex Limited is debating whether it should maintain the status quo or adopt a new strategy.22 + 1.000 Fixed assets 25.09 % Hence the value of the firm is : 70 = Rs. If it maintains the status quo: • The sales will remain at 50. the turnover ratios. What value will the new strategy create? . Income statement Balance Sheet Sales Gross margin (20%) Selling & general adminStration (8%) Profit before tax Tax Profit after tax 50.000 • The gross margin will remain at 20% and the selling. will remain unchanged. the capital structure.59 x 0.000 Equity 30.

000 10.500 10.955 9.500 6.805 – 30.000 Balance Sheet Projections 42. .Increase in net current assets = Operating cash flow Present value factor Present value • • • • 5.805 2.000 16.250 54.250 4.460 2.000 1.098 3 109.850 21.675 = 44.000 32. The income statement for year 0 (the year which has just ended) and the balance sheet at the end of year 0 for Megastar Limited are as follows.769 0.675 (3539) (4038) 9.910 54.925 10.760 10.227 3.450 10.000 30.805 4200 • Pre-strategy value = = 30.000 5.910 50.535 (4602) (5983) 0.850 21.500 16.985 50.900 1.182 3.098 9.500 39.500 (3540) 0.340 5.955 9.042 7.200 1 65.970 8.227 Present value of the operating cash flow stream = (10682) Residual value = 9227 / 0.182 3.000 13.700 65.227 5.000 5.907 Present value of residual value = 65907 x 0.493 – 9.950 2.788 13.000 = 3.985 65.227 Residual value 3+ 109.Solution: Income Statement Projections Current Values (Year 0) 50.000 39.800 2.700 65.877 (3105) Cash Flow Projections 7.487 Total shareholder value = 44.970 8.000 4.000 1.000 30.227 • Sales • Gross margin (20%) • Selling and general administration (8%) • Profit before tax • Tax • Profit after tax • Fixed assets • Net current assets • Total assets • Equity 25.140 3.225 13.910 Profit after tax + Depreciation .910 65.900 6.200 7.493 5.000 6.Capital expenditure .14 • Value of the strategy = 33.000 0.487 – 10682 = 33.460 2 84.925 8.800 4.788 13.4 = 65.

296 Balance sheet projections 195. general.447 23.000 Income statement projections 1 2 3 4 260.000 14. the capital structure.000 Megastar Limited is debating whether it should maintain the status quo or adopt a new strategy.800 43.296 63. its sales will grow at the rate of 30 percent per year for three years.500 329.981 31.000 20.000 250.400 439.000 50.900 72.000 439.550 329. What value will the new strategy create? Solution: Current values Year Sales Gross margin Selling and general administration Profit before tax Tax Profit after tax Fixed assets 0 200.Income statement Balance Sheet Sales Gross margin (25%) Selling & general adminStration (10%) Profit before tax Tax Profit after tax 200.471 94.000 14.190 28. After three years.000 253. Thereafter.000 33. the income tax rate. however. will remain unchanged.400 65.850 109. The margins. sales will remain constant.453 48. Depreciation charges will be equal to 20 percent of the net fixed assets at the beginning of the year.850 26. If it maintains the status quo: • • • • • • The sales will remain at 200.000 50.000 20.810 150.000 338.550 . and administrative expenses will be 10 % of sales Depreciation charges will be equal to new investments The asset turnover ratios will remain constant The discount rate will be 15 percent The income tax rate will be 33 percent If Megastar Limited adopts a new strategy.471 18.000 43.500 109. and the discount rate.689 63.190 28.000 84. capital expenditure will be equal to depreciation.000 Net current assets 100.175 31.670 94.175 37.000 The gross margin will remain at 25% and the selling.000 Fixed assets 150. the turnover ratios.000 250.000 43.940 55.810 Equity 250.940 43.

000 250.296 65.000 325.811) (63. (i) What will be the ROCE for year 3 ? Assume that the capital employed is measured at the beginning of the year.000 50.15)3 Total shareholder value=(111.02 630 630 12% 12% 68. After 8 years. Assume that the straightline method of depreciation is used for tax as well as shareholder reporting purposes.910 65.453 30.250 63.02 630 12% 75.250 549.067 (25.452 166.700 97.296 39.000 (37.500 549.6 (Rs.480 million in fixed assets and Rs.80 million every year.000 37.in million) 2 3 420 360 150 150 570 510 80 80 60 60 39.4 61.172 100.454) 219. The cost of capital for the project is 12 percent. The plant has an economic life of 8 years and is expected to produce a NOPAT of Rs.296 (111. (ii) What will be the EVA (Rs.910 0 63. A new plant entails an investment of Rs.000 130.280) 421.02 39.000 75.in million) for year 3 ? (iii) What will be the ROGI for year 3 ? (iv) What will be the CVA (Rs.296/0.250 Cash Flow projections 48.15 Present value of the residual value = 421.970 277.630 million (Rs.000 30.700 549.172 192.700 422.750 39.000 325.Net current assets Total assets Equity Profit after tax Depreciation Capital expenditure Increase in net current assets Operating cash flow Present value of the operating cash flow stream Residual value = 63.700 (48.280) +277452 Pre-strategy value = 28810/0.689 63.067 – 166.000 219.895) 3.150 million in net working capital).250 422.500 126.2 .000 250. the net working capital will be realised at par but fixed assets will fetch nothing.970/(1.in million) for year 3 ? (v) What will be the CFROI for year 3? Solution: • • • • • • • • • Net fixed assets (beginning) Net working capital (beginning) Capital employed (beginning) NOPAT Depreciation (Accounting) Economic depreciation Cash investment Cost of capital Capital charge 1 480 150 630 80 60 39.000 50.500 549.15 Value of the strategy =192.547) 169.

Assume that the straight line method of depreciation is used for tax as well as reporting purposes.38 Operating cash flow – Economic depreciation CFROI = Cash investment = 630 140 –39.depreciation – Capital charge on full capital invested = (80 + 60) – 39.02 12.8 NOPAT + DEP ROGI3 = CASH INVESTMENT = 630 80 + 60 = 480 = 39.12 x 510 = 18.65 800 10% 74 3 480 200 680 90 60 37.02 = 16.02 – 0.90 million every year.600 million in fixed assets and Rs. The cost of capital for the project is 10 percent. The plant has an economic life of 10 years and is expected to produce a NOPAT of Rs. 8yr ROCE3 = NOPAT3/CE = 80/510 = 15. (ii) What will be the EVA for year 3 ? (iii) What will be the ROGI for year 3 ? (iv) What will be the CVA for year 3 ? (v) What will be the CFROI for year 3? Solution: • • • • • • • • • Net value of fixed assets (beginning) Investment in net working capital Capital employed (beginning) NOPAT Depreciation (Accounting & tax) Economic depreciation Cash investment Cost of capital Capital charge 1 600 200 800 90 60 37.03% 3.200 million in net working capital). the net working capital will be realised at par whereas fixed assets will fetch nothing.69% EVA3 = NOPAT – COC x CE = 80 – 0. (i) What will be the ROCE for year 3 ? Assume that the capital employed is measured at the beginning of the year.12 x 630 = 25.65 800 10% 68 .30 = 22. A new plant entails an investment of Rs.800 (Rs.480 Economic depreciation = FVIFA12%. After 10 years.22% CVA3 = Operating cash flow – Eco.65 800 10% 80 2 540 200 740 90 60 37.

1000 million (Rs. the net working capital will be realised at par whereas fixed assets will fetch nothing.35 Operating cash flow – Economic deprn CFROI = Cash investment = 14.600 Economic depreciation = FVIFA10%.deprn – Capital charge on full cap.75% CVA3 = Operating cash flow – Eco.40 1000 15% 3 640 200 840 140 80 39.200 million in net working capital).937 = 18.24% EVA3 = NOPAT – COC x CE = 90 – 0.65 – 80 = 32.10 x 680 = 22 NOPAT + DEP ROGI3 = Cash Invest = 800 90 + 60 = 600 = 37. (i) (ii) (iii) (iv) What will be the EVA for year 3? What will be the ROGI for year 3? What will be the CVA for year 3? What will be the CFROI for year 3? Solution: 1 • • • • • • • • 2 720 200 920 140 80 39.40 1000 15% Net value of fixed assets (beginning) Investment in current assets Capital employed (beginning) NOPAT Depreciation (Accounting and tax) Economic depreciation Cash investment Cost of capital 800 200 1000 140 80 39.140 million every year. The cost of capital for the project is 15 percent. 10yr ROCE = NOPAT3/CE = 90/680 = 13. After 10 years. Assume that the straight line method of depreciation is used for tax as well as reporting purposes.65 15. The plant has an economic life of 10 years and it is expected to produce a NOPAT of Rs.40 1000 15% .04% 4. A new plant entails an investment of Rs.invested = 150 – 37. 800 million in fixed assets and Rs.The net working capital will be maintained at that level throughout the project life.

300 = B k–g 5 B = Rs.60. Biotech International earns a return on equity of 20 percent.40 = 1000 = 18.304 39. 60 .20 = 0. The book value per share is Rs. The dividend payout ratio is 0.75 x 0.15 x 840 = 14 NOPAT + DEP ROGI3 CVA3 = Cash Investment = 1000 = 800 = 20.15 M = 5 B = Rs.20 – 0. according to the Marakon model ? Solution: g = (1-b)r = 0. = 220 – 39.15 M r–g 0.25.40 140 + 80 = 22 % = OPERATING CASH FLOW – ECONOMIC DEPRECIATION – CAPITAL CHARGE ON FULL CAPITAL INVESTMENT.16 – 0.40 – 0.800 Economic depreciation = FVIFA15%. (i) What is the market price per share.15 = = 0.60 OPERATING CASH FLOW – ECONOMIC DEPRECIATION CFROI3 = CASH INVESTMENT 220 – 39.15 (1000) = 30. 10 EVA3 = = NOPAT3 – COC x CE 140 – 0.06% 5. Equity shareholders of Biotech require a return of 16 percent.

900 19.994 1.000 30.811 9.992 3 32. Initial outlay : Project life : Salvage value : Annual revenues : Annual costs : (excluding depreciation.280 13. 0. PBIT 1 50.000 30.189 Depreciation Schedule • Investment (beginning) • Depreciation • 10% capital charge • Annuity 1.000 9.189 21.000 30.19 b = 0.000 30.000 9.199 13.189 60. 5years) = 50.000 ⇒ A = 13.289 13.091 4 22.000 8.189 5.994 11.909 3. Revenues 2.900 2.008 4.181 13.100 5 11. Costs 3.74 % 6.811 2 41.994 18.000 A x 3.(ii) Solution: If the return on equity falls to 19 percent.909 20.000 30.000 10.006 .189 60.000 30.000 8. what should be the payout ratio be to ensure that the market price per share remains unchanged.803 9.1525 0.1974 or 19.000 30. PBDIT 4.894 10.16 – g g = (1-b) r g = 0.000 11.189 60. Depreciation 5.791 = 50. interest.000 30.000 13.008 20. Miocon Limited is considering a capital project for which the following information is available.000 30. and taxes) 50000 5 years 0 60000 30000 Depreciation method (for tax purposes) Tax rate Debt-equity ratio Cost of equity Cost of debt (post-tax) : : : : : Sinking fund 30 % 1:1 14% 6% Calculate the EVA of the project over its life.1525 = (1-b) x 0.000 30.189 60. Solution: Sinking Fund Depreciation A x PVIFA (10%.19 – g = 5 0.189 60.

669 52.000 11.000 90.000 : 4 years : 0 : 250.142 64.525 17.268 14.6.000 42.268 50.102 = 200.378 58.000 A x 3. 15.385 15.000 64.997 157.385 64.000 : Sinking fund : 30% : 1:1 : 15% : 7% Solution: Sinking Fund Depreciation A x PVIFA ( 11 %. Calculate the EVA of the project over its life.000 1 200.268 200.475 1 250.289 11.333 12.147 17.000 160.000 90. 7.199 11. EVA 7.475 4 250. Capital at charge 8.000 58.045 47.000 5. 4.000 160. : 200.853 29.268 • Investment (beginning) • Depreciation • 11% Capital charge • Annuity 1.328 12.11) EVA A = 64475 Depreciation Schedule 2 3 4 157.475 22. 5. 2.513 14.475 47.181 10.803 3.000 90.000 160.000 47.000 22. NOPAT (5) x 0. 9. Capital charge (7 x 0.475 3 250.000 90.333 37.328 64.7 7.10) 9. 3.525 110. Initial outlay Project life Salvage value Annual revenues Annual costs Depreciation method (for tax purposes) Tax rate Debt-equity ratio Cost of equity Cost of debt (post tax) The initial outlay is entirely for acquiring fixed assets.142 14.000 160.784 13.378 12.081 12. Revenues Costs PBDIT Depreciation PBIT NOPAT (5) x (0. 4yrs ) = 200.894 2.525 33.604 11.994 1.090 6.280 10.952 5 5 .405 Janbaz Limited is considering a capital project for which the following information is available.064 32. 6.000 : 160.7) Capital at charge Capital charge (7 x 0.367 110.694 41.000 10.000 52.147 42.910 22.337 58.811 4.000 42.370 22.090 31.475 2 250.045 6.667 26.225 58. 8.

000 A x 3.5yrs) = 10. and taxes) 10000 5 years 0 14000 9000 Depreciation method (for tax purposes) Tax rate Debt-equity ratio Cost of equity Cost of debt (post-tax) : : : : : Sinking fund 30 % 1 :1 16% 8% Calculate the EVA of the project over its life and the NPV. PBDIT 5000 5000 5000 4. Polytex Limited is considering a capital project for which the following information is available .53 4 14000 9000 5000 2211 2789 1952 4689 563 1389 5 14000 9000 5000 2477 2523 1766 2478 297 1469 (1.12) 1200 1011 800 9.000 → A = 2774 Depreciation Schedule 1 2 3 10. Investment outlay : Project life : Salvage value : Annual revenues : Annual costs : (excluding depreciation interest.12)4 +1469/ = 4724.12 + 1255/(1.12)5 . PBIT 3426 3237 3026 6.000 8426 6663 1574 1763 1974 1200 1011 800 2774 2774 2774 • Investment(beginning) • Depreciation • 12% Capital charge • Annuity 4 4689 2211 563 2774 5 2478 2478 297 2774 1 2 3 1. Capital at charge 10000 8426 6663 8.12)2 +1318/(1.7) 2398 2266 2118 7.12)3 + 1389/(1. NOPAT (5) x (0.8. Depreciation 1574 1763 1974 5. Revenues 14000 14000 14000 2.605 = 10.12)t = 1198/1. EVA 1198 1255 1318 EVAt NPV = ∑ (1. Costs 9000 9000 9000 3. Capital charge (7x 0. Solution: Sinking Fund Depreciation A x PVIFA (12%.

Simtek Limited is considering a capital project for which the following information is available. 7. 3. 6. What will be the EVA for year 3? Revenues Costs PBDIT Depreciation PBIT NOPAT Capital at charge Capital charge EVA 10000 6400 3600 1579 2021 1415 5331 640 775 .00 percent Sinking Fund Depreciation A x PVIFA (12%. Investment outlay : Project life : Salvage value : Annual revenues : Annual costs : (excluding depreciation interest.9. and taxes) (i) 8000 5 years 0 10000 6400 Depreciation method (for tax purposes) Tax rate Debt-equity ratio Cost of equity Cost of debt (post-tax) : : : : : Sinking fund 30 % 0. 2. 8.63 + 9. 5. 4.37 =12. 9. 5yrs) = 8000 A x 3.6 :1 15% 7% What will be the depreciation charge for year 3? Solution: 6 Post-tax cost of capital: 16 x7+ 10 x 15 16 2.605 = 8000 ⇒ A = 2219 Depreciation Schedule 1 8000 • Investment (beginning) 1259 • Depreciation 960 • 12 percent charge 2219 2 6741 1410 809 2219 3 5331 1579 640 2219 (ii) Solution: 1.

92 million . Pinnacle Corporation expects to earn a supernormal rate of return of 60 percent on new investments to be made over the next 4 years. decrease or remains unchanged? Solution: The book capital decreases over time. 10.23) = Rs. The projected new investment per year is Rs.18) 4 Value of forward plan = 0. This leads to an increase in EVA over time. what is the value of the forward plan? Solution: I r c* T = = = = Rs. thanks to depreciation. If the weighted average cost of capital for Pinnacle Corporation is 18 percent.200 million 0.200 million.18) = Rs. Karishma Limited expects to earn a supernormal rate of return of 50 percent on new investments to be made over the next 6 years.56 million 11.(iii) Over time will the EVA of this project.50 – 0.400 million 0.400 million. what is the value of the forward plan? Solution: I r c* T = = = = Rs.23) 6 Value of forward plan = 0. increase. If the weighted average cost of capital for Karishma Limited is 23 percent.60 – 0.18 (1.23 6 years 400 (0.2290.60 0. The projected new investment per year is Rs.50 0.23 (1. 1581.18 4 years 200 (0. Hence the capital charge decreases.

in million) Anil Company (Rs. The fair market value of the fixed assets and current assets of Anil Company was assessed at Rs. Sunil and Anil Company. under the ‘pooling’ method as well as the ‘purchase’ method are shown below: Before Amalgamation After Amalgamation Sunil & Anil Company Pooling method Purchase method 70 95 55 60 Sunil Fixed assets Current assets Total assets Share capital (face value @ Rs.CHAPTER 34 1.10 face value) Reserves and surplus Debt 45 40 85 30 20 35 85 25 15 40 10 20 10 40 The share swap ratio fixed is 2:5. in million) Fixed assets Current assets Total assets Share capital (Rs. The pre-amalgamation balance sheets of Sunil Company and Anil Company are as follows: Sunil Company (Rs.10) Capital reserve Reserves & surplus Debt Total liabilities 45 40 85 30 Anil 25 15 40 10 125 34 6 40 45 125 155 34 56 20 45 155 20 35 85 20 10 40 . Solution: The pre-amalgamation balance sheets of Sunil Company and Anil Company and the post-amalgamation balance sheet of the combined entity.20 million respectively. Anil Company (the transferor company) and Sunil Company (the transferee company) amalgamate in an exchange of stock to form Anil and Sunil Company.50 million and Rs. Prepare the post-amalgamation balance sheet of Sunil & Anil Company under the 'pooling' and 'purchase' methods.

The preamalgamation balance sheets of Yin Company and Yan Company are as follows: Yin Company (Rs.10 face value) Reserves and surplus Debt 120 240 360 150 150 60 360 50 80 130 40 10 80 130 The exchange ratio fixed is one share for every two shares of transferor company. in million) Fixed assets Current assets Total assets Share capital (Rs.2. Yan Company (the transferor company) and Yin Company (the transferee company) amalgamate in an exchange of stock to form Yin Yan Company. Prepare the post-amalgamation balance sheet of Yin Yan Company under the 'pooling' and 'purchase' methods. Rs.40 million . The pre-amalgamation balance sheets of Jai Company and Bharat Company are as follows: . in million) Yan Company (Rs. current assets and debt of Yan Company was assessed at Rs. The fair market value of the fixed assets. Solution: Yin Fixed assets Current assets Goodwill Total assets Share capital (face value @ Rs.90 million respectively.60 million and Rs. 120 240 Yan 50 80 Yin & Yan Company Pooling method Purchase method 170 320 160 300 10 470 170 360 150 130 40 490 170 20 160 140 490 150 60 360 10 80 130 150 150 470 Bharat Company (the transferor company) and Jai Company (the transferee company) amalgamate in an exchange of stock to form Jai Bharat Company.10) Capital reserve Reserves & surplus Debt Total liabilities 3.

current assets and debt of Bharat Company was assessed at Rs. The following are the relevant financials of the two companies.20 million and Rs.100 million 10 million Rs.Jai Company (Rs.30 million.200 Ajay Company Rs. Vijay Company Rs. in million) Fixed assets Current assets Total assets Share capital (Rs.10) Capital reserve Reserves & surplus Debt Total liabilities 4.40 million respectively . Rs.200 million 20 million Rs. Prepare the post-amalgamation balance sheet of Jai Bharat Company under the 'pooling' and 'purchase' methods. E Number of outstanding shares Market price per share .10 face value) Reserves and surplus Debt 80 100 180 70 50 60 180 40 40 80 30 20 30 80 The exchange ratio fixed is two shares for every five shares of the transferor company. The fair market value of the fixed assets. After Amalgamation Jai Bharat Company Pooling method Purchase method 120 110 140 120 2 232 82 180 70 80 30 260 82 18 70 90 260 50 60 180 20 30 80 50 100 232 Vijay Company plans to acquire Ajay Company.120 Total earnings. Solution: Before Amalgamation Jai 80 100 Bharat 40 40 Fixed assets Current assets Goodwill Total assets Share capital (face value @ Rs. in million) Bharat Company (Rs.

53 (iii) If there is no synergy gain.S1 ER1 = S2 20 = 10 + + PE12 (E12) P1 S2 18 (300) = 0. 200 PE12 = 300 = x 20 + 300 100 x 12 13. at what level of PE multiple will the lines ER1 and ER2 intersect? Solution: The lines ER1 and ER2 will intersect at a point corresponding to the weighted average of the two PE multiples wherein the weights correspond to the respective earnings of the two firms.33 .06) -120 x 10 = 0.(i) What is the maximum exchange ratio acceptable to the shareholders of Vijay Company if the PE ratio of the combined company is 18 and there is no synergy gain? Solution: .7 200 x 10 (ii) What is the minimum exchange ratio acceptable to the shareholders of Ajay Company if the PE ratio of the combined company is 18 and there is a synergy gain of 6 percent? Solution: P2S1 ER2 = (PE12) (E1 + E2) (1+S) – P2S2 120 x 20 = (18) (200 + 100) (1.333 + 4 = 17.

The following are the relevant financials of the two companies.945 (200 + 100) (1. E Number of outstanding shares Market price per share (i) What is the maximum exchange ratio acceptable to the shareholders of Jeet Company if the PE ratio of the combined company is 21 and there is no synergy gain? Solution: .1200 = Rs. 400 million and the exchange ratio agreed to is 0.08) = 11 20 + 10 x ER (v) Assume that the merger is expected to generate gains which have a present value of Rs.6 x 10 PV (Vijay & Ajay) = 4000 + 1200 + 400 = 5600 million Cost = 0.93. what exchange ratio will result in a post-merger earnings per share of Rs.231 20 + 0.1600 million 40 million Rs .600 million 30 million Rs. Jeet Company Rs. What is the true cost of the merger from the point of view of Vijay Company? Solution: Cost = α PV (Vijay and Ajay) – PV ( Ajay) 0. Jeet Company plans to acquire Ajeet Company.360 Total earnings.60 x 10 α = = 0.6.900 Ajeet Company Rs.231 x 5600 .6 million 5.(iv) If the expected synergy gain is 8 percent.11? Solution: (E1 + E2) (1 + S) = N1 + N2 x ER ER = 0.

ER1 = .X 18 2200 PE12 = = = .08) .378 = = (ii) What is the minimum exchange ratio acceptable to the shareholders of Ajeet Company if the PE ratio of the combined company is 20 and there is a synergy benefit of 8 percent? Solution: ER2 = P2S1 -------------------------------------------(PE12) (E1 + E2) ( 1 + S) – P2S2 360 x 40 -------------------------------------------20 x (2200) (1.S1 + PE12(E12) ---------------------P1S2 .91 21.392 = = (iii) If there is no synergy gain.360 x 30 0.5 + 2200 16.40 + 21 x 2200 ---------------------30 900 X 30 0. 1600 ---------.x 22.27 600 ---------.36 + 4. at what level of PE multiple will the lines ER1 and ER2 intersect? Solution: The lines ER1 and ER2 will intersect at a point corresponding to the weighted average of the two PE multiples wherein the weights correspond to the respective earnings of the two firms.S2 .

5000 million and the exchange ratio agreed to is 0.10 ) (E1 + E2 ) ( 1 + S ) ----------------------.750 million Rs. What is the true cost of the merger from the point of view of Jeet Company? Solution: Cost α = = α PV (Jeet & Ajeet) .= --------------------------N1 + N2 x ER 40 + 30 x ER 2420 ------------------40 + 30ER ER = 1. Shaan Company Aan Company Total earnings.250 Rs.355 = 30 = 30 (v) Assume that the merger is expected to generate gains which have a present value of Rs.240 million Number of outstanding shares 50 million 20 million Market price per share Rs.6 6.PV (Ajeet) 0. E Rs.45 x 30 −−−−−−−−−−−− 40 + 0.150 (i) What is the maximum exchange ratio acceptable to the shareholders of Shaan Company if the PE ratio of the combined company is 15 and there is no synergy gain? .30 ? Solution: ( 1600 + 600 ) ( 1.252 PV ( Jeet & Ajeet ) = 36000 + 10800 + 5000 = 51800 PV ( Ajeet ) = 10800 Cost = 0.45 x 30 = 0.(iv) If the expected synergy gain is 10 percent.45. what exchange ratio will result in a post-merger earnings per share of Rs.252 ( 51800 ) – 10800 = 2253. The following are the relevant financials of the two companies. Shaan Company plans to acquire Aan Company.

67 + 990 240 x 12. at what level of PE multiple will the lines ER1 and ER2 intersect? Solution: The lines ER1 and ER2 will intersect at a point corresponding to the weighted average of the two PE multiples wherein the weights correspond to the respective earnings of the two firms. 750 PE12 = 990 = 15.589 (iii) If there is no synergy gain.S1 ER1 = S2 50 = 20 + + PE12 ( E 12) P1 S2 15 x 990 = 0.5 .06 – 150 x 20 = 0.47 250 x 20 (ii) What is the minimum exchange ratio acceptable to the shareholders of Aan Company if the PE ratio of the combined entity is 15 and there is a synergy benefit of 6 percent? Solution: P2S1 ER2 = (PE12) (E1 + E2) (1+S) – P2S2 150 x 50 = 15 x 990 x 1.66 x 16.Solution: .

22 million Cost = Cash compensation – PVV = Rs.2 million .40 million and Varun Company has a value of Rs.20 million Benefit = Rs.194 62 = 16100 50 + 20 x 0.(iv) If the expected synergy gain is 6 percent. 7. If the two companies merge.20 million.40 million.06) = 16 50 + 20 x ER ER = 0.779 (v) Assume that the merger is expected to generate gains which have a present value of Rs.194 x 16100 – 3000 = Rs. 600 million and the exchange ratio agreed to is 0. Arun proposes to offer Rs.60.3 million NPV to Varun = Cash Compensation – PVV = Rs. What is the net present value of the merger to the two firms? Solution: PVA = Rs.5 million would occur. what exchange ratio will result in a post-merger earnings per share of Rs.4 million.123.60 PV (Shaan & Aan) = 12500 + 3000 + 600 PV (Aan) = 3000 Cost = 0.16? Solution: (E1 + E2) (1 + S) = N1 + N2 x ER ( 750 + 240) (1.60 x 20 α = 12 = = 0.22 million cash compensation to acquire Varun. cost savings with a present value of Rs. PVV = Rs.2 million NPV to Arun = Benefit – Cost = Rs.5 million. Cash compensation = Rs. Arun Company has a value of Rs. What is the true cost of the merger from the point of view of Shaan Company? Solution: Cost = α PV (Shaan & Aan) – PV ( Aan) 0.

000 = 800.80 million and Jamal Company has a value of Rs.000 = Rs.30 million Benefit = Rs. PVA = Rs.000 Market price per share Number of shares The merger is expected to bring gains which have a present value of Rs.2 . prior to merger announcement.12 million.10 million would occur.5 million NPV to Alpha = Benefit – Cost = Rs.000 + 200. America Limited plans to acquire Japan Limited.000 Japan Limited Rs. PVJ = Rs.40 300.104 million Exchange ratio = 2:3 The share of Japan Limited in the combined entity will be : α 200.80 million.35 million cash compensation to acquire Jamal. If the two companies merge.5 million NPV to Beta = Cash Compensation – PVJ = Rs.12 million PVAJ = 80 + 12 + 12 = Rs.5 million 9. 100 800.12 million Benefit = Rs.8. The relevant financial details of the two firms. Cash compensation = Rs 35 million Cost = Cash compensation – PVJ = Rs.000 = 0.10 million. What is the net present value of the merger to the two firms? Solution: PVK = Rs. cost savings with a present value of Rs. Required : (a) What is the true cost of America Limited for acquiring Japan Limited ? (b) What is the net present value of the merger to America Limited ? (c) What is the net present value of the merger to Japan Limited ? Solution: Let A stand for America Limited and J for Japan Limited and AJ for the combined entity. Kamal Company has a value of Rs.40 x 300. America Limited offers two share in exchange for every three shares of Japan Limited.30 million. are given below: America Limited Rs. Kamal proposes to offer Rs.100 x 800.000 = Rs.80 million PVJ = Rs.

100 200.000 α = = 0. Amir Limited plans to acquire Jamir Limited. Required: (a) What is the true cost of Amir Limited for acquiring Jamir Limited? (b) What is the net present value of the merger to Amir Limited ? (c) What is the net present value of the merger to Jamir Limited ? Solution: Let A stand for Amir Limited and J for Jamir Limited and AJ for the combined entity.500 x 600.8. are given below: Amir Limited Rs.2 x 104 .20 million PVAJ = 300 + 20 + 20 = Rs.0769 x 340 . 500 600.000 Jamir Limited Rs.a) True cost to America Limited for acquiring Japan Limited Cost = α PVAJ .3.PVJ = 0.000 Market price per share Number of shares The merger is expected to bring gains which have a present value of Rs.8 = Rs. The relevant financial details of the two firms.6.000 = Rs.340 million Exchange ratio = 1:4 The share of Jamir Limited in the combined entity will be: 50.PVJ = 0.0769 600.8 million 10.000 + 50.000 = Rs.300 million PVJ = Rs.8. PVA = Rs.8 million NPV to America Limited = Benefit .20 million.2 million NPV to Japan Limited = Cost = b) c) Rs.Cost = 12 .8.000 a) True cost to Amir Limited for acquiring Jamir Limited Cost = α PVAJ .12 = Rs.100 x 200. prior to merger announcement. Amir Limited offers one share in exchange for every four shares of Jamir Limited.20 million Benefit = Rs.20 = Rs.146 million .

56 .2. Rs.30 per share cash compensation to Regional Company and (ii) offers two shares for every five shares of Regional Company? Solution: Let the suffixes A stand for National Company.50 (1.6. The following facts are given: National Company Rs.55.72 million The required return on the equity of Regional Company is the value of k in the equation.00 3.000 Regional Company Rs.000 Earning per share Dividend per share Price per share Number of shares Investors currently expect the dividends and earnings of Regional to grow at a steady rate of 6 percent.1704 .000 = Rs.12) = 0.8.6.24.3.24 x 3. the intrinsic value per share would become: 2.04 per cent.146 million 11.854 million c) NPV to Jamir Limited = Cost = Rs.12 Rs.13.24 = k .. B for Regional Company and AB for the combined company.06 k = 0..1704 or 17.00 Rs.50 Rs.2. Required : (a) What is the benefit of this acquisition ? (b) What is the cost of this acquisition to National Company if it (i) pays Rs.5.06) Rs.50 (1.00 Rs. a) PVB = Rs.000.146 = Rs. After acquisition this growth rate would increase to 12 percent without any additional investment. As the financial manager of National Company you are investigating the acquisition of Regional Company. If the growth rate of Regional rises to 12 per cent as a sequel to merger.Cost = 20 .86.00 Rs.000.b) NPV to Amir Limited = Benefit .00 8.000.

68 million If National pays Rs. (ii) So shareholders of Regional will end up with 1.10.00 5.68 .68 million = Rs.39.56 = (b) (i) Rs.94.000 Devaraj Limited Rs.38 .800.00 1.00 Rs. Required: (a) What is the benefit of this acquisition ? (b) What is the cost of this acquisition to Satya Limited if it (i) pays Rs.000 Earning per share Dividend per share Price per share Number of shares Investors currently expect the dividends and earnings of Devaraj to grow at a steady rate of 4 percent.56 Hence the benefit of the acquisition is: 3 million x Rs.31.854.PVB = .Thus the value per share increases by Rs.4. If National offers 2 shares for every 5 shares it has to issue 1.18 million.04 per cent 8+ 1.94.110.1304 or 13.12.00 Rs.30 per share cash compensation.00 Rs.2 million shares to shareholders of Regional.24) = Rs.3.68 million So the cost of the merger is : Cost = α PVAB .400.86x8 million + Rs.24x3 million + Rs. = Rs.00 Rs.72 12. The following facts are given: Satya Limited Rs.30 – Rs.45 million As the financial manager of Satya Limited you are investigating the acquisition of Devaraj Limited.2 α = = 0.1304 x 854.2 shareholding of the combined entity. the cost of the merger is 3 million x (Rs.31.100 per share cash compensation to Devaraj Limited and (ii) offers three shares for every seven shares of Devaraj Limited ? . After acquisition this growth rate would increase to 10 percent without any additional investment. The present value of the combined entity will be PVAB = PVA + PVB + Benefit = Rs.

If the growth rate of Devaraj Limited rises to 10 per cent as a sequel to merger.3 (1.8 + 0.6 α = = 0.6 million shares to shareholders of Devaraj Limited...09375 or 9.32 = (b) (i) Rs.111.149.8 million + Rs.86.85 million = Rs.155.10) = 0.1221.38 x 1.000 = Rs.155. the cost of the merger is 1.32 acquisition is 1. The present value of the combined entity will be PVAB = PVA + PVB + Benefit = Rs.38) = Rs.04) Rs.100 – Rs.4 million + Rs.2 million The required return on the equity of Devaraj Limited is the value of k in the equation. So shareholders of Devaraj Limited will end up with 0.10 Thus the value per share increases by Rs.38x1.32 If Satya Limited pays Rs.100 per share cash compensation.53.38 = k . (iii) If Satya Limited offers 3 shares for every 7 shares it has to issue0 . the intrinsic value per share would become : 3(1. Rs.85 million Hence the benefit of the Rs.110x5.6 shareholding of the combined entity. B for Devaraj Limited and AB for the combined company a) PVB = Rs.4million x Rs.375 per cent 5.4 million x (Rs.21 per cent.05 million .1221 or 12.400.Solution: Let the suffixes A stand for Satya Limited.8 million.847.04 k = 0.111.

2 = Rs. Companies P and Q are valued as follows: P Earnings per share Rs.4.000 132.00 Rs.12.72 Number of shares Aggregate earnings Market value P/E .00 Price per share Rs.804. M N Combined entity 100.000 M acquires N by offering one shares of M for every three shares of N.884.360.000 Rs.000 8 4.000 Rs. 12.09375 x 847.53.05 .000 Rs.4. P 60.000 Rs.00 32. 37.000 Rs.36.000 Rs.6.188.000 Rs.94 Number of shares Aggregate earnings Market value P/E 14.000 P acquires Q by offering one shares of P for every three shares of Q.500.000 9.000 Rs.4.110.00 Rs.696.00 Number of shares 100.28.000 8.42 7.000 Q Rs.000 Rs.000 N Rs.720.45. If there is no economic gain from the merger. 7.000 32.84.600. what is the price-earnings ratio of P's stock after the merger? Solution: The expected profile of the combined entity after the merger is shown in the last column below.588. If there is no economic gain from the merger.21 million 13.000 Rs.0 Combined entity 81. Companies M and N are valued as follows: M Earnings per share Rs.1.000 7.696.00 Number of shares 60.26.So the cost of the merger is : Cost = α PVAB .00 21.384.000.000 Rs.53.PVB = .00 Price per share Rs.17 Q 21. what is the price-earnings ratio of M's stock after the merger? Solution: The expected profile of the combined entity after the merger is shown in the last column below.000 Rs.

15)4 150 + (1.15)5 . in million) 60 80 100 150 120 Beyond year 5. The number of outstanding shares of X Limited and Y Limited prior to the merger are 20 million and 12 million respectively.15)3 100 + (1.15)5 0. 2706.15)3 (1. Solution: Value of X Limited’s equity as a stand-alone company.50 x 1244. the equity-related cash flows of the combined firm are expected to be as follows: Year 1 2 3 4 5 Cash flow (Rs. 1244. If Y Limited is acquired.15 – 0.75 1 (1.15)2 (1.15)4 (1. Since the management of X Limited wants to ensure that the net present value of equity-related cash flows increases by at least 50 percent. If the management wants to ensure that the net present value of equity-related cash flows increase by at least 50 percent. the cash flow is expected to grow at a compound rate of 10 percent per year.27million Let abe the maximum exchange ratio acceptable to the shareholders of X Limited.27= 1.08 x (1.15) (1.08 120 x 1.10) + + + + + x (1. X Limited is planning to acquire Y Limited.15)2 80 + (1.15.15)5 120 + 0. what is the upper limit on the exchange ratio acceptable to it ? Assume cost of capital to be 15 percent. to be as follows: Year 1 2 3 4 5 Cash flow (Rs. the cash flow is expected to grow at a compound rate of 8 percent per year for ever. The management of X Limited estimates its equity-related post tax cash flows.33 20 + a 12 Solving this for a we get a = 0. as a sequel to the merger. without the merger.15 – 0. the value of a is obtained as follows.10 = Rs. 60 + (1. in million) 100 120 150 250 200 Beyond year 5.15) (1.33 million Value of the equity of the combined company 100 120 150 250 200 200 (1. 20 x 2706.15)5 1 = Rs.

13 – 0.04 = Rs.61 = 1.13)5 Let a be the maximum exchange ratio acceptable to the shareholders of P Limited.89 10 + a 8 Solving this for a we get a = 0. The number of outstanding shares of P Limited and Q Limited prior to the merger are 10 million and 8 million respectively.13) (1. 10 x 628. the cash flow is expected to grow at a compound rate of 8 percent per year.04 + + + + + x (1. Since the management of P Limited wants to ensure that the net present value of equity-related cash flows increases by at least 20 percent.13) (1.13 – 0. If the management wants to ensure that the net present value of equity-related cash flows increase by at least 20 percent. 297.13)5 1 (1. in million) 20 30 40 40 30 Beyond year 5.13) (1.20 x 297. 628. without the merger.13) (1. what is the upper limit on the exchange ratio acceptable to it ? Assume cost of capital to be 13 percent. The management of P Limited estimates its equity-related post tax cash flows.08 = Rs.08) + + + + + x 2 3 4 5 (1. as a sequel to the merger.61 million 1 (1.13)4 (1.95 . the equity-related cash flows of the combined firm are expected to be as follows : Year 1 2 3 4 5 Cash flow (Rs. If Q Limited is acquired. to be as follows: Year 1 2 3 4 5 Cash flow (Rs.13) (1. P Limited is planning to acquire Q Limited.13)5 0. the value of a is obtained as follows. Solution: Value of P Limited’s equity as a stand-alone company. 20 30 40 40 30 30 x 1.89 million Value of the equity of the combined company 30 50 60 50 40 40 (1.16.13)3 (1.13)2 (1. the cash flow is expected to grow at a compound rate of 4 percent per year for ever. in million) 30 50 60 50 40 Beyond year 5.13) 0.

4 25.5 15 3 138 27.8 8 6 177.06 10. Rs.20 – 0.60 = Rs.92 million.17.833 (8. CMX Limited is interested in acquiring the cement division of B&T Limited.20)6 = 25.13. Rajagiri Mills Limited is interested in acquiring the textile division of Pricom Industries Limited.33) 2 (8.471 V0 = .9) 0.5) 0.13. 18.3 6 Asset value (at the beginning) NOPAT Net investment Growth rate (%) The growth rate from year 7 onward will be 6 percent.471 PV(VH) = (1. 11. The discount rate to be used for this acquisition is 20 percent.4 8 5 163.1 0.8 30.482 0 5 0 0. What is the value of this acquisition? Solution: 1 FCF PVIF PV (10) 0.6 32. The planning group of CMX Limited has developed the following forecast for the cement division of B & T Limited.335 3.402 0 6 10.in millions Year 1 100 20 30 20 2 120 23 32. The planning group of Rajagiri Mills Limited has developed the following forecast for the textile division of Pricom Industries Limited.694 (5.60 = 0.579 (2.90) 3 (4.4 30.1 35.7 PV (FCF) during the explicit forecast period = .8 32.5 10 4 151.837) 4 0 0.383 7 10.706 = 76.68 FCF7 VH = r-g 76.68 + 25.9 32. .

10 = 93.5 r–g 0.567 0.37 = .87) (0.5 193.5) (7) (2.0 10 The growth rate from year 7 onward will be 10 percent.4 FCF7 1.2 24.893 0.in millions Year 1 100 20 35 40 2 140 25 36.5 277.37 = Rs. What is the value of this acquisition? Solution: FCF PVIF PV PV (FCF) VH PV (VH) V0 19.80 22.87 = = = 93.17) (4.1 25.797 0.3 20 15 12 10 8 The growth rate from year 7 onward will be 8 percent. 16.84) (1.7 42.7 43. The discount rate to be used for this acquisition is 15 percent.712 0.3) 1. The planning group of Rex Limited has developed the following forecast for the cement division of Flex Limited Year 1 100 14 20 25 2 3 4 5 6 Asset value NOPAT Net investment Growth rate(%) 125 150 172.7 0.98) (1.636 0. The discount rate to be used for acquisition is 12 percent.50 17.5 25 3 175 30 37 20 4 210 34.Rs.1 29.0 15 43.40 + 47.97 million 7 Rex Limited is interested in acquiring the cement division of Flex Limited.30.5 37.507 (13.86) during the explicit forecast period = -3.9) (3.5 / (1.7 39.5 24.40) (9.5 22.4 15 5 6 Asset value (at the beginning) NOPAT Net investment Growth rate (%) 241.2 212.12 – 0.2 27. 1 2 3 4 5 6 (15) (11.5 21 24. What is the value of this acquisition? .12)6 = 47.

22) (3.497 1.Solution: FCF PV 1 (6) 2 (5) 3 (1.870 0.15 – 0.26 (1.23.432 1. Though Astra Pharma has a reasonable presence in this segment. with a general upward trend.9 0. Max Drug is a two decade old company with a turnover of Rs.71 MINI CASE Astra Pharma is a fairly diversified pharmaceutical company that has presence of most of the therapeutic segments. the business development group at the head office examined several independent pharmaceutical companies with a primary focus on the cardiovascular segment. In a recent strategy session. thanks to a balanced programme of internal growth and acquisitions. Based on such analysis. market capitalisation.756 0.5 0.15) 6 V0 = – 6.3040 million last year. it zeroed in on Max Drugs as a potentially suitable candidate for acquisition by Astra Pharma.78) (0.5) 4 0 5 3 0. and so on. The financial statements of Astra Pharma and Max Drugs for last year are given below: .26 = Rs. attitude of incumbent management.50 6 4. This group looked at things like revenues. Max has had a chequered history. the management of Astra Pharma identified the cardiovascular segment as a thrust area for the next few years.08 1 PV(VH) = 70 x = 30.94 7 4.99) – PV (FCF) during the implicit forecast period FCF7 4.658 (5.55 + 30. It has grown at a healthy rate over the past fifteen years. the management is keen on pursuing aggressive growth opportunities in this segment. profit margin.9 = = 70 VH = r-g 0. On the advice of the management. especially through acquisitions. growth rate.

and taxes Depreciation Profit before interest and taxes Interest Profit before tax Tax Profit after tax Max Drugs Balance Sheet 9680 1920 500 1420 80 1340 440 900 Shareholder's Funds (10 million shares. earnings per share. and taxes Depreciation Profit before interest and taxes Interest Profit before tax Tax Profit after tax 1520 230 70 160 30 130 35 95 The market price per share of Astra Pharma is Rs. Rs 10 par) Loan funds 4600 600 5200 Fixed assets (net) Investments Net current assets 3300 500 1400 5200 Astra Pharma Profit and Loss Account Sales Profit before depreciation. .360 and the market price per share for Magnum Drugs is Rs.Astra Pharma Balance Sheet Shareholder's Funds (40 million shares. Rs 10 par) Loan funds 1300 500 1800 Fixed assets (net) Investments Net current assets 940 250 610 1800 Max Drugs Profit and Loss Account Sales Profit before depreciation. interest. interest. (a) Calculate the exchange ratio that gives equal weightage to book value per share. and market price per share. 110.

So.5 1044.5 + 110/360 )/3 = 0. [(900 + 95) (1.(b) (c) (d) (e) If the merger is expected to generate a synergy gain of 5 percent. the EPS of the merged company should be at least Rs.5/22.62 If there should not be initial dilution of EPS. What is the maximum exchange ratio acceptable to the shareholders of Astra Pharma if the PE ratio of the combined entity is 15 and there is no synergy gain? What is the minimum exchange ratio acceptable to the shareholders of Max Drugs if the PE ratio of the combined entity is 14 and there is a synergy benefit of 2 percent? Assuming that there is no synergy gain. earnings per share and market price per share = (130/115 + 9.5.360 Rs 22.75 = 900 + 225 ER Therefore maximum exchange ratio ER = 0.58 Exchange ratio that gives equal weightage to book value per share. what is the maximum exchange ratio Astra Pharma should accept to avoid initial dilution of earnings per share? What will be the post-merger EPS of Astra Pharma if the exchange ratio is 1:3? Assume that there is no synergy gain.Outstanding shares S Shareholders’ funds Market price per share P EPS Book value PE ratio (a) 900 million 40 million 4600 million Rs.22. at what level of the PE ratio will the lines ER1 and ER2 intersect? Assume that the merger is expected to generate gains which have a present value of Rs.64 (b) . 1000 million and the exchange ratio agreed to is 1:3.05)] / [40 + ER x 10] = 22. What is the true cost of the merger from the point of view of Astra Pharma? What are the limitations of earnings per share as the basis for determining the exchange ratio? List the five sins that plague acquisitions? (f) (g) (h) (i) Solution: Astra Earnings E No.5 Rs 115 16 Max 95 million 10 million 1300 million Rs.5 Rs 130 11.110 Rs 9.

69% share of Astra Pharma. the PE of the merged company has to be 16 and therefore maximum exchange ratio Astra Pharma should accept is = .600 995 PE12 .34 To get the level of the PE ratio where the lines ER1 and ER2 will intersect we have to solve the following for PE12 .000 / [40.96 Maximum exchange ratio acceptable to the shareholders of Astra Pharma = -S1 / S2 + PE12(E12)/P1S2 = -40/10 + (15 x 995)/(360 x 10) = 0.840.000.64] (c) Post-merger EPS of Astra Pharma = 995.000.05)] / (360 x 10) = 0.094.328.S1 + S2 P1S2 (E1 + E2) PE12 = PE12 (E1 + E2) – P2S2 P2S1 (d) (e) (f) .000 990.422.000. 22.000 PE12 -1. So they will get α = (10/3) / ( 40 + 10/3) = 7.500PE12 + 15. The present value of Astra Pharma after the merger will be = 40 x 360 + 10 x 110 + 1000 = Rs. shareholders of Max drugs will get 10/3million shares of Astra Pharma.025 PE212 = 15.[Alternatively: As the EPS of Astra if remains unchanged.15 Minimum exchange ratio acceptable to the shareholders of Max Drugs = P2S1 / ( P12E12 – P2S2) = (110 x 40) / [ 14 x (995x1.S1 / S2 + PE12 (E12)/P1S2 = -40/10 + [16x 995(1.400 = 3.58 (g) At the exchange ratio of 1:3.1100 4.500 PE12 PE12 = 15.400 990.000/3] = Rs.40/10 + 995 PE12 / 360 x 10 = (110 x 40)/ [ PE12 x 995 -110 x 10] 995PE12 – 14.840.000 + 10.16500 million Therefore the true cost of the merger from the point of view of Astra Pharma .000 = 15.025PE212 -14.02) – 110 x 10] = 0.

what is the annualised forward premium on the dollar? Solution: The annualised premium is: Forward rate – Spot rate x Spot rate 40.85 million (h) An exchange ratio based on earnings per share fails to take into account the following: (i) The difference in the growth rate of earnings of the two companies.0769 x 16500 – (10 x 110) = Rs. If the spot rate of the US dollar is Rs.00 = 40.= 0.00 and the six month forward rate is Rs.00 and the three month forward rate is Rs. (ii) The gains in earnings arising out of merger.02 % . (i) The five sins that plague acquisitions are the following: a) b) c) d) e) Straying too far afield.40. Leaping before looking.110.168.5 % Forward contract length in months 12 If the spot rate of the US dollar against Japanese yen 114. Failing to integrate well. what is the annualised forward premium on the yen ? Solution: The annualised premium is : 114 – 110 = 114 x 6 12 = 0.25. CHAPTER 37 1.00 2. x 3 12 = 0. Overpaying.025 or 2.25 – 40. (iii) The differential risk associated with the earnings of the two companies.0702 or 7.40. Striving for bigness.

The current spot rate is Rs.0525 x F A forward exchange rate of Rs.0245 dollars per sterling pound will mean indifference between investing in the U.0341 dollars per sterling pound.S and in the U.53 x 1. ? Solution: 300 300 (1.75 percent.40. You are considering deposits in the US or U.000(1.K.K.39. The exchange rate between US dollar and yen is as follows: Spot 114.K. what is it likely to be in Japan? Solution: (a) The annual percentage premium of the yen on the dollar may be calculated with reference to 30-days forwards .000 100.48 percent (for 6 months). The US interest rate on 1 –year deposit of this size is 5.S. The current spot rate is 2.30 yen per dollar Required: (a) What is the annual percentage premium of the yen on the dollar ? (b) What is the most likely spot rate 6 months hence? (c) If the interest on 6-month deposit in the US is 2.K.000 to invest.54 yen per dollar 30-day forwards 114.50 per dollar What forward exchange rate will make you indifferent between investing in India and the the US .53 per dollar will mean indifference between investing in India and the U.0575 x F A forward exchange rate of 2.0245 x 1.0341 F = 2. is 5.100.0525) = 2. You have Rs. What forward exchange rate will make you indifferent between investing in the US and depositing in the U. The US interest rate on 1 –year deposit of this size is 5. The rate of interest on a 1-year deposit of this size in U. You have $300 million to invest. 4.11 yen per dollar 90-day forwards 113. Solution: 100.08) = 39.34yen per dollar 180-day forwards 112.25 percent.50 F = 40. You are considering deposit in India or the US. 5.3.25 percent while the rate for a one year deposit in India is 8 percent .

54 1.64 % The most likely spot rate 3 months hence will be : 1.28 percent (for 3 months).5915 x 1.5915 AUD per EUR 30-day forwards 1.11 x 114.48 per cent for 6 months.88 per cent( for 3 months) .0248 1 + foreign interest rate 1 + domestic interest rate in Japan 1 + domestic interest rate Domestic interest rate in Japan = 0.6008 AUD per euro Forwards rate = Spot rate 1.5950 AUD per EUR 90-day forwards 1.6008 AUD per EUR Required: (a) What is the annual percentage premium of the euro on the AUD ? (b) What is the most likely spot rate 3 months hence? (c) If the interest on 3-month deposit in Euro land is 2. The exchange rate between euro and Australian dollar (AUD) is as follows: Spot 1. what is it likely to be in Australia ? Solution: The annual percentage premium of the euro may be calculated with reference to 30days forwards 1.6008 = 1.5950 – 1.54 – 114.54 (b) (c) 12 = 4.114.0228 1 + foreign interest rate 1 + domestic interest rate in Japan 1 + domestic interest rate Domestic interest rate in Japan = 0.5915 (b) (c) 1 12 = 2. 6.30 yen / dollar Forwards rate = Spot rate 112.3 = 114.0288 = 2.00476 = 0.50 % 1 The most likely spot rate 6 months hence will be : 112.5915 1.

40 (1.17)1 + (1.17)3 16. rf = 5.08 / 1.08 / 1. Navabharat Corporation.17)2 10.033 10.40 100 40.300 + (1. the NPV in rupees is: 4.055)1 = Rs.29 The expected rupee cash flows for the project Year Cash flow in dollars Expected exchange (million) rate -200 39.908 .033 NPV = -7.40.42. an Indian company. 39.055)3 = Rs. 39.055)5 = Rs.40 (1.27 Rs. The project will entail an initial outlay of USD 500 million and is expected to generate the following cash flow over its five year life: Year 1 Cash flow 100 (in USD millions) 2 250 3 400 4 400 5 300 The current spot exchange rate is Rs.055)4 = Rs.7.880 + (1.08 / 1.43. the risk-free rate in India is 8 percent and the risk-free rate in the US is 5.27 Rs.39.27 300 44. Calculate the NPV of the project using the home currency approach.40 per US dollar. 39.08 / 1.40 .41.33 Rs.5 per cent Hence the forecasted spot rates are : Year Forecasted spot exchange rate 1 2 3 4 5 Rs.287 0 1 2 3 4 5 Given a rupee discount rate of 17 per cent. Solution: S0 = Rs.055)2 = Rs.40 (1.40 (1.300 16. 39. is considering a project to be set up in US.27 400 43.39.39.29 Cash flow in rupees (million) -7.880 4.40 (1.908 17.08 / 1.308 13. Navabharat Corporation’s required rupee return on a project of this kind is 17 percent.44.33 250 41.2 400 42.5 percent. rh = 8 per cent .29 Rs.

41.17)4 + 13.39. 39 (1. Calculate the NPV of the project using the home currency approach.00 per US dollar. Solution: S0 = Rs.07 / 1.944.07 / 1.40 = 734.40.06 Rs.27 Rs. 28.92 million The dollar NPV is : 28.07 / 1. the risk-free rate in India is 7 percent and the risk-free rate in the US is 5 percent. 39 (1.39 (1.07 / 1. is considering a project to be set up in US.05)6 = Rs.17.07 / 1.07 / 1.05)3 = Rs.42.43.86 Rs.50 Rs.17)5 = Rs.92 / 39.74 Rs. rh = 7 per cent .42. Ashoka Limited’s required rupee return on a project of this kind is 22 percent.287 (1.39.05)5 = Rs.64 million dollars 8. Ashoka Limited .308 + (1.944. 39 (1. The project will entail an initial outlay of USD 800 million and is expected to generate the following cash flow over its six year life: Year 1 2 3 4 5 6 Cash flow 200 350 500 800 700 500 (in USD millions) The current spot exchange rate is Rs.05)4 = Rs. 39 (1.67 The expected rupee cash flows for the project .39 .05)2 = Rs. an Indian company. 39 (1. rf = 5 per cent Hence the forecasted spot rates are: Year 1 2 3 4 5 6 Forecasted spot exchange rate Rs.05)1 = Rs.

200 + + + (1.25 percent in the U S and 1.67 Cash flow in rupees (million) .22)3 33.22)2 (1.74 350 40.835 Given a rupee discount rate of 22 per cent.27 800 42. What will be the 90-day forward rate? + (1. 29.50 percent in U K and the current spot exchange rate is $ 2.22)5 30.635 NPV = -31.Year 0 1 2 3 4 5 6 Cash flow in dollars Expected exchange (million) rate -800 39. What will be the 90-day forward rate? .31.0125 1 + .175 20.51 million dollars 9.635 33.114 million The dollar NPV is: 29.06 700 42.175 20.648 + (1.015 / £ 10.835 ------(1.200 7.0150 F = $ 2.4203/euro.86 500 43.002 21.22)4 = Rs.948 14.27 percent in the U S and 1.02/£.648 30.114 / 39 = 746. The 90-day interest rate is 1.948 14. the NPV in rupees is : 7.07 percent in Euro land and the current spot exchange rate is $ 1.50 500 41.002 + 21.00 200 39.22)6 Solution: Forward rate = Spot rate F = 2.02 1 + domestic interest rate 1 + foreign interest rate 1 + . The 90-day interest rate is 1.22)1 (1.

05 1.03 So. The current spot rate for the British pound is Rs.57. the expected spot rate a year from now is : 81 x (1.40 1 + expected inflation in home country 1 + expected inflation in foreign country 1.0127 1 + .4203 1 + domestic interest rate 1 + foreign interest rate 1 + .81 1 + expected inflation in home country 1 + expected inflation in foreign country 1. the expected spot rate a year from now is : 56. The current spot rate for the euro is Rs.82.Solution: Forward rate = Spot rate F = 1.027 So.0107 F = $ 1.50 . What is the expected spot rate of British pound a year hence? Solution: Expected spot rate a year from now = Current spot rate Expected spot rate a year from now = Rs. What is the expected spot rate of euro a year hence? Solution: Expected spot rate a year from now = Current spot rate Expected spot rate a year from now = 56.4231/ euro 11.56.7 percent in U K.04 1.05 / 1.027) = Rs.81 The expected inflation rate is 4 percent in India and 2.04 / 1.03) = Rs.03 12.40 The expected inflation rate is 5 percent in India and 3 percent in Euro land.40 x (1.

000 in India and $460 in the UK. Suppose India and UK produce only one good.30 330 (b) 15.000 in India and $330 in Singapore. What should the one year British Pound: Rupee forward rate be? Solution: (a) The spot exchange rate of one British Pound should be : 28000 = Rs. 65. Suppose India and Singapore produce only one good. 30. what should the Singapore dollar: Rupee spot exchange rate be? (b) Suppose the price of tin over the next year is expected to rise to Rs.28000 and in the UK it is $400. tin. a.26.30. Suppose the price of copper in India is Rs.13. According to the law of one price. (a) According to the law of one price.10. and the inflation rate in Japan is expected to be 0. Suppose the price of tin in India is Rs.67 300 One year forward rate of one Singapore dollar should be : 10000 = Rs. copper.4 percent per year. If the current spot rate is 114 yen/$ what will be the expected spot rate in 3 years? (1 + expected inflation in Japan)3 (1 + expected inflation in UK)3 Solution: Expected spot rate = Current spot rate x 3 years from now . The inflation rate in US is expected to be 2. what should the British Pound : Rupee spot exchange rate be? b.70 400 One year forward rate of one British Pound should be : 30000 = Rs.22 460 (b) 14. What should the one year Singapore dollar: Rupee forward rate be? Solution: (a) The spot exchange rate of one Singapore dollar should be : 8000 = Rs.7 percent per year.8000 and in Singapore it is Singapore dollar 300. Suppose the price of copper over the next year is expected to rise is Rs.

2345 = $ 101.9736 x 0.65 Invest AUD 117.2500 = 18.05 (90/360)] Riskless profit = $ 101. for 90 days and get 117.a. U.25 Suppose the spot rate between USD and INR is 46.(1.a.5% p.017) 17.8530 = $ 101.S dollars can be lent or borrowed at a rate of 5% p.5 % p.027) 16. while the rates for AUD deposits or loans is 4. 3 = 106.41per euro Suppose the spot rate between AUD and USD is 0.5% p.a. while the rate for USD deposits or loans is 6.50 INR per USD. This is denoted as USD/INR.a.58.65 @ 4. Indian rupee can be lent or borrowed at a rate 8 % p. The 90-day forward is 47.20.035)2 = 56. 10.4845 Repay USD by paying 100 [ 1 + 0. How much risk-less profit can you make on a borrowing of 100 USD. This is denoted as AUD/USD.045 (90/360)] = AUD 118.8500 Borrow 100 USD and convert it into AUD 117. and the inflation rate in India is expected to be 3.4845 .8530. The 90-day forward is 0.$ 101.8530 AUD/ USD 0.000? . How much risk-less profit can you make on a borrowing of Rs. 56. Solution: Spot 90-day forward 0.7 percent per year.4 per euro what will be the expected spot rate in 2 years? Solution: (1 + expected inflation in India)2 Expected spot rate = Current spot rate x 2 years from now (1. 2 (1 + expected inflation in euro currency area)2 = Rs.9736 Convert AUD into USD at the forward rate and receive dollars = AUD 118. If the current spot rate is Rs. 0.a.5 percent per year.004)3 = 114 x (1.4 x (1.51 yen / $ The inflation rate in euro currency area is expected to be 1.8500 USD per AUD.65 [ 1 + 0.

088 Repay INR loan by paying 10. The 180-day money market rate for deposits in UK is 2.088 = INJR 115.05 [1 + 0.09 19.20 Borrow 10.10200 = INR 115.05 Invest USD 215.5 % p.000) by using 180-day money market deposit rate applicable to the foreign country.50 90 – day forward 47. What steps should the Indian firm take to do a money market hedge? Solution: (i) Determine the present value of the foreign currency liability (£500.08 ( 90/360) ] = 10. This works out to : £500.805 (1.088 .Solution: USD/INR Spot 46. This investment will grow to £500. An Indian firm has a liability of £500.000 on account of purchases from a British supplier.000 after 180 days .20 = INR 10315.a for 90 days and get 215.000 INR and convert it into USD 215.54 X 47.200 Riskless profit = 10315.5 percent.54 Convert USD into INR at the forward rate and receive INR USD 218.805 on today’s spot market (iii) Invest £487.000 [ 1 + 0.025) (ii) Obtain £487. which is payable after 180 days.065 (90/360)] = USD 218.805 in the UK money market.05 @ 6.000 = £ 487.

400. ( This is the interest rate for a USD deposit) USD/ INR spot : 46.80 Maturity value of the USD = 2.157 which will compound to £400000 after 90 days with the collection of the receivable. The funds can be parked for a six-month period.70/46.719.170.00 If Sagar Ltd. 21. Eurodollar 6 month LIBOR : 5 % p.20.14 Rupee equivalent at the forward rate of 46.000 Amount deposited in USD = 46.80 USD/ INR 6months forward : 46.102. which is payable after 90 days.94 x 46.000) by using the 90-day money market borrowing rate of 2 per cent.94 = $2.90 Rs. if covered forward? Solution: 100.90/ 47.719 % .136.157 in the UK money market and convert them to rupees in the spot market.000 = £ 392. Sagar Ltd has a short-term fund surplus of Rs. What steps should the Indian firm take to do a money market hedge? Solution: (i) Determine the present value of the foreign currency asset (£400.017.000 on account of exports to a British firm.000.170.02) (ii) Borrow £392.05 (180/360)] = $ 2. (iii) Repay the borrowing of £392.14 [1 + 0.190.100 million. what rupee rate of return will it finally get over the 6 month period.90 per USD = = Rupee rate of return = $ 2.0 percent.157 (1.a.136.10 2. An Indian firm has a receivable of £400. The company observes the following rates in the market.752. parks its funds in the US dollar.752.190. The 90-day money market borrowing rate in UK is 2.

100.752.05 (180/360)] = $2. The funds can be parked for a six month period.50/43.S dollar.913.S.80/43.58 [1 + 0.a ( This is the interest rate for a USD deposit) USD/INR spot : 43. What return will it finally get over the 6-month period.220.80 per USD = 123. Eurodollar 6 month LIBOR : 5% p.000.6137 .000.97 % 23.000 43.0297 or 2.821.752.000.50 / 55. Eastern Industries Ltd has a short.564. if covered forward? Solution: Amount deposited in USD = 120.30/120. dollar.293.22.term fund surplus of Rs.000 spot? Solution: 20.000.220.92 Rupee equivalent at the forward rate of 43.60 USD/INR 6 month forward : 43.58 Maturity value of the USD deposit = 2.000 = 110. and threemonth forward.90 If Eastern Industries parks its funds in the U. 70 / 75 What would you receive in dollars if you sold Yen 20.55 $ 180.30 Rate of return = 3.293. A foreign exchange dealer in London normally quotes spot. (i) 50/ 55.60 = $2. When you ask over the telephone for current quotations for the Japanese yen against the U. one-month.564. you hear: 110. The company observes the following rates in the market.120 million.000 = 0.

50 + 0.60 ) ( 115.000.000 = $343.75 ) = 111.90 (ii) What would it cost you to purchase JPY 40. The market rates are as follows: Mumbai USD/INR Spot : 43.20 / 111. A foreign exchange dealer in London normally quotes spot. 40/45.000.000 forward three-months with dollars? Solution: Three months outright = ( 110.30 30.000.20/30 3-months : 115.90 + 0.50/60 Singapore USD/JPY Spot : 115.000.000.000 forward three-months with dollars ? $258.1727 What would you receive in dollars if you sold Yen 30.55 = 40. Suppose an Indian firm has a 3-month payable of JPY 80 million. one-month and threemonth forward.83 Solution: Three months outright = (115.000.000 = 111. 60/65 (i) Solution: = $ 269.50/60 3-months : 44.61 116.784.80/90.20 24.55 + 0. you hear 115.40 25. When you ask over the telephone for current quotations for the Japanese Yen against the US dollar.65) = 116.000 spot? 30.843.10/20 .80 + 0.40 116.(ii) What would it cost you to purchase JPY 30.642.70 ) / ( 110.000 = 115.

how much will it have to pay? 80. The historical relationship is as follows: Average percentage change in P = 0.40/ 50 Singapore: a. (a) If an investor owns Rs.40 Rupees required = = USD 675.20/ 30 45.If the firm buys JPY forward against INR.999.013.130.5).01 + 0. Solution: If the firm buys JPY forward against INR.000.2 million of P.000 USD required = 118.80/ 90 118.675. Price changes of two pharmaceutical stocks. how much will it have to pay? Solution: USD required = 80. 30. are positively correlated.50 (Percentage change in Q) Changes in Q account for 50 per cent of the variation of changes in P (R2 = 0.675.047.513.78 x 44.78 Rupees required = = 26.68 X 45. USD 695.000. 31.90 Rs.047.68 CHAPTER 40 1.000 115.60 Rs. P and Q.71 = USD 675. how much of Q should he sell to minimise his risk? (b) What is his hedge ratio? (c) How should he create a zero value hedge? .99 Suppose an Indian firm has a 3-month payable of JPY 80 million. The market rates are as follows: Mumbai: USD/ INR spot 3 months USD/ JPY spot 3 months : : : : 46.50/ 60 118.10 = USD 695.

000 and the three month stock index futures is trading at 18.84 per cent.08) 0.5 5100 = 5000 (1. On an annual basis it is approximately 4. What is the average annual dividend yield on the stocks in the index? Solution: Futures price = Spot price (1+Risk-free rate)0.200. The investor must short sell Rs. The risk-free annual rate is 8 per cent.067 per cent.08) 0.100.4 million (Rs.5 The dividend yield on a six months basis is 1. On an annual basis it is approximately 3.92 per cent.2 million in a bank. The stock index is currently at 18.2 million / 0. 3.50) of Q His hedge ratio is 0.25 18200 = 18000 (1.268 per cent. The risk-free annual rate is 9 per cent.5 5000 x Dividend yield (1. .09) 0. The stock index is currently at 5.5 Spot price x Dividend yield (1+Risk-free rate)0.Solution: (a) (b) (c) 2.25 Spot price x Dividend yield (1+Risk-free rate)0.25 18000 x Dividend yield (1. What is the average annual dividend yield on the stocks in the index? Solution: Futures price = Spot price (1+Risk-free rate)0.09) 0.000 and the six month stock index futures is trading at 5.25 The dividend yield on a three months basis is 1.50 To create a zero value hedge he must deposit Rs.

857.10.000 per ton Rs.13) 1 = Spot price + Present value of – Present value storage costs of convenience yield Hence the present value of convenience yield is Rs.14 per ton. .9.207 per ton.4.000 = 150.000 per ton Rs.800 = 10.800 for a one year contract 12 per cent Rs.150.800 per year What is the PV (convenience yield) of gunmetal scrap? Solution: Futures price (1+Risk-free rate)1 160. The following information about gunmetal scrap is given: • • • • 1 = Spot price + Present value of – Present value storage costs of convenience yield Spot price Futures price Interest rate PV (storage costs) : : : : Rs.000 for a one year contract 13 per cent Rs.10.000 + 800 – Present value of convenience yield (1. 5. The following information about copper scrap is given: • • • • Spot price Futures price Interest rate PV (storage costs) : : : : Rs.160.000 + 500 – Present value of convenience yield (1.12)1 Hence the present value of convenience yield is Rs.500 per year What is the PV (convenience yield) of copper scrap? Solution: Futures price (1+Risk-free rate) 10.

• Sumit Corpn.6. Solution: LIBOR.50 % • • Cost of Fixed Rate Funding Cost of Floating Rate Funding 6-month LIBOR + 100 bp 6 month LIBOR+25 bp . 5% Fixed Rate Firm B Desired Funding Fixed Rate $ 5 years 40 million 7% Floating Rate $ 5 years 40 million 5.5 % and the balance of savings is shared equally between the two firms. Consider the following data Firm A • Swap Bank LIBOR50bp 5% Sumit Ltd. Assume that the bank wishes to earn 0.5% Amit Ltd. Consider the following data Amit Corpn. LIBOR + 50bp 7.0 % Desired Funding Fixed Rate 5 years 50 million 7. Floating Rate 5 years 50 million 5.0 % • • Cost of Fixed Rate Funding Cost of Floating Rate Funding 6-month LIBOR +50 bp 6 month LIBOR Show how both the parties can save on funding cost by entering into a coupon swap with the help of a swap bank.50 bp 5.

25%] = 0.0.25% 6month LIBOR+50bp 5% 6 month LIBOR . The share of each in the savings is therefore 0.00% .5.25%. a swap can be arranged as shown in the following diagram.Show by way of a diagram how the parties can save on funding cost by entering into a coupon swap with the help of a swap bank. To realise this.5%) – (LIBOR + 1. Assume that the cost saved is shared equally by the two firms and the bank. Fixed Rate $ 5 years 200 million Apple Ltd Floating Rate $ 5 years 200 million Desired Funding Cost of Fixed Rate Funding: Cost of Floating Rate Funding: 6. 8. Consider the following data: Excel Corpn.LIBOR . Solution: The total savings that will be effected will be [(7% .75%.

You have another client B which has easy access to floating USD market at SubLIBOR cost of LIBOR-50 bp. Show how the swap can be executed. Assume that swap bank incurs savings in one currency and an additional payment obligation in other currency. Its funding cost in EUR is 5. As a swap banker. Show diagrammatically how you will arrange such a swap.25% while it is willing to pay floating at six-month LIBOR plus 50 bp. for arranging a swap in such a way that the savings is split equally among all the three. a swap banker. Solution: 9. .Both the companies have approached you. It would like EUR funding at no more than 5% to acquire some EUR fixed rate assets. you are approached by client A who has to fund itself in fixed rate EUR though it prefers floating rate USD funding.

Solution: .

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